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One more point on Martin Wolf

by Brad Setser
December 22, 2004

It is a simple point, but an important one. Wolf says the United States would be fine if it reduced its current account deficit from 6% of GDP to 3% of GDP. External debt to GDP then stabilizes at 50% of GDP. All true.

But remember that cutting the current deficit in half likely requires cutting the trade deficit by much, much more. Right now, net interest payments on US external debt are close to zero. That is largely due to a combination of good investments (The US accumulated a lot of European assets when it was running current account surpluses in the 50s and 60s, and these assets generally provide the US with a decent return) and good luck: foreigners hold lots of US debt, and US interest rates are very low.

But over time, as debt levels rise and US interest rates rise, the income balance will turn negative. If the US pays just 4% interest on a (net) external debt to GDP ratio of 50%, interest payments would be 2% of GDP. A 3% of GDP current account deficit therefore is consistent with a trade deficit of 1% of GDP — compared to about 6% of GDP now.

This oversimplifies. If the US continues to earn a higher rate of return more on its offshore assets than it pay on its external liabilities, its “income” from borrowing abroad to invest abroad (what I call financial intermediation) will offset some of the interest payments on its net debt. A net external debt of 50% of GDP might imply external assets of 50% of GDP and external debts of 100% of GDP. Suppose the US pays 4% on all its liablities, and earns 5% on its assets. US net interest payments would be 1.5% of GDP in this scenario. Then a trade deficit of 1.5% of GDP is consistent with a current account deficit of 3% of GDP.

My point is simple: cutting the current account deficit in half over time will require cutting the trade deficit by more than half. Realistically, the trade deficit (technically, the balance on trade and transfers) will need to fall by between 4.5 and 5% of GDP …

There is no guarantee that the US will be able to bring its current deficit down to 3% in an orderly way. Emerging markets typically do not adjust smoothly. Rather, once capital inflows dry up, they swing from current account deficits to current account surpluses. They rarely end up in the sweet spot — that is, they typically are not able to run the small ongoing current account deficits that can be consistent with a stable debt to GDP ratio.

Then, again, the US is not (yet) an emerging economy — even if its debt to exports ratio is starting to look rather scary by any standard. Yet it is not inconceivable that foreign investors could completely lose confidence in the US during the inevitable adjustment process that reduces the US current account deficit from 6% of GDP to 3% of GDP. In that scenario, the US would lose the ability to attract the ongoing inflows needed to sustain a current account deficit of 3% of GDP, and be forced to adjust more. Sometimes external creditors put a country on a very short least, and demand that it reduce its debt to GDP ratio. Unlikely to happen to the US. Yes. Impossible. No.

36 Comments

  • Posted by anne

    Then there are my Asian friends and acquaintences who have been steadily buying residential and commercial property here as a hedge against possible problems in Asia. They buy in western Canada as well. Are they concerned about currency value changes? I am asking.

  • Posted by anne

    http://www.nytimes.com/2004/12/23/business/worldbusiness/23canada.html?pagewanted=all&position=

    China Emerging as U.S. Rival for Canada’s Oil
    By SIMON ROMERO

    CALGARY, Alberta – China’s thirst for oil has brought it to the doorstep of the United States.

    Chinese energy companies are on the verge of striking ambitious deals in Canada in efforts to win access to some of the most prized oil reserves in North America.

  • Posted by anne

    http://www.nytimes.com/2004/12/23/business/23truffle.html?pagewanted=all&position=

    Leave No Truffle Behind?
    By EDUARDO PORTER

    At Le Bernardin, the four-star Manhattan seafood restaurant, the prix fixe menu these days runs a hefty $92. But Eric Ripert, the owner and chef, winces every time a customer orders the wild salmon on a bed of asparagus.

    “If you choose the salmon you kill us,” Mr. Ripert said. “We are losing money every time we sell a portion.”

  • Posted by L

    For an excellent analysis of this issue see this Levy Economics Institute paper by Godley, Izurieta, and Zezza:
    “Why Net Exports Must Now Be the Motor for US Growth”

    Link, top article listed in center col: http://www.levy.org

  • Posted by anne

    http://www.nytimes.com/2004/12/23/opinion/23thurs1.html

    America, the Indifferent

    It was with great fanfare that the United States and 188 other countries signed the United Nations Millennium Declaration, a manifesto to eradicate extreme poverty, hunger and disease among the one billion people in the world who subsist on barely anything. The project set a deadline of 2015 to achieve its goals. Chief among them was the goal for developed countries, like America, Britain and France, to work toward giving 0.7 percent of their national incomes for development aid for poor countries.

    Almost a third of the way into the program, the latest available figures show that the percentage of United States income going to poor countries remains near rock bottom: 0.14 percent. Britain is at 0.34 percent, and France at 0.41 percent. (Norway and Sweden, to no one’s surprise, are already exceeding the goal, at 0.92 percent and 0.79 percent.)

  • Posted by anne

    Warren Buffett wrote a fine essay about our balance of payments problem last December for Fortune Magazine. I had missed the essay, till today.

  • Posted by brad

    anne — jeff sachs was on charlie rose last night, making much the same argument … the bush administration’s much touted development aid program — the millenium challenge account — has yet to disburse a dollar …

    bilmon — good points. nouriel and i did a similar exercise in our external adjustment paper, but we let the adjustment happen more gradually, over ten rather than five years: it took 10 years of exports growing at 9% y/y and imports at 5.5% or so. in that scenario, external debt to GDP stabilizes at @ 55%, and the current account deficit in 2014 is 3.5% -3% …

  • Posted by Billmon

    The number crunching exercises only highlight the overwhelming importance of a gradual adjustment, in which the arithmetic of compounding works for us, not against us. However, this will require the Asian central banks to continue funding extremely large U.S. payments deficits for many years to come – probably well past the point where a rational evaluation of their own narrow self interest (i.e. export market share) would lead them to pull the plug and cut their losses.

    So the question becomes: How much of a strategic interest does China have in preserving the existing international monetary order (BWII) and its entente cordiale with the United States?Enough to absorb the increasing domestic economic costs required to keep the system afloat until our debt-to-GDP ratio has stablized?

    It seems to me a gradual adjustment would require a hell of a lot of trust (an extremely rare commodity in international monetary relations.) The members of the Asian central bank cartel would have to trust each other not to cheat on their reserve policies (the prisoners dilemma problem.) And they would all have to trust the United States to stick with the adjustment program – rather than simply taking advantage of BWII to keep living the high life as long as humanly possible. I guess to a certain extent the Asians would also have to trust the Europeans not to lever the euro lower against the dollar AND the yen AND the renminbi, and trust OPEC not to completely decouple oil prices from the dollar (a lesser risk, I admit, but given Asian fuel bills, not one they can completely ignore.)

    Somehow none of this is sounding particularly plausible to me.

    Of course, if my 5-year time line proves more realistic than Brad and Nouriel’s 10-year time line, it increases the likelyhood that a 1.5%-of-GDP trade deficit will be unsustainable, and that the U.S. will have to move to a trade surplus in order to bring the current account into balance.

    Remind me again why John Kerry wanted to be president?

  • Posted by anne

    Surely we ought to be very annoyed at ourselves for a foolishly selfish lack of willingness to focus on such a thoroughly humane program as agricultural development assistance.

  • Posted by anne

    An abstract that was posted on Steve Hsu’s fine Blog:

    http://www.princeton.edu/~markus/research/papers/hedgefunds_bubble.htm

    Abstract:

    ‘This article documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. This does not seem to be the result of unawareness of the bubble: Hedge funds captured the upturn, but, by reducing their positions in stocks that were about to decline, avoided much of the downturn. Our findings question the efficient markets notion that rational speculators always stabilize prices. They are consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage.’

  • Posted by anne

    My sense of the article, and how hedge funds might accentuate our balance of payments problem:

    Again, if I understand, stock hedge funds caught as they had to were they to survive the bubble market in technology. But, they were able to leave the technology sector stock by stock as the declines began and preserved gains. Interesting.

    While we might think that hedge funds would bet against a forming bubble, and provide limits to the inflation, there is reason to expect the opposite. Why not bet with the bubble, knowing that bubble it is. After all, your investors expect you at least to keep up in a bull market and not to keep up in a bubble will cost you investors. There might also be a sense that there is no bubble, simply rising asset prices with which you wish to keep up. The problem with simply going along with the rise is forgetting how readily a turn can come. So, we have the hedge fund manager who will contribute to the bubble and continually be looking for reasons to sell.

  • Posted by anne

    Billmon

    Interesting posts!

  • Posted by anne

    Billmon:

    “How much of a strategic interest does China have in preserving the existing international monetary order (BWII) and its entente cordiale with the United States? Enough to absorb the increasing domestic economic costs required to keep the system afloat until our debt-to-GDP ratio has stablized?”

    When the question is so asked, my answer is all the interest of China rests in sustained 7% economic growth and a lessening of income inequality. China’s development model is working, leadership will change the model with most caution.

  • Posted by anne

    Billmon:

    “If the US is going to have a personal savings rate in the neighborhood of, well, 0%, and a net national savings rate in the barely 2% range, we ARE going to run a current account deficit – and probably a very large one – under just about any plausible economic scenario I can imagine.”

    Agreed!

  • Posted by Billmon

    “China’s development model is working, leadership will change the model with most caution.”

    No doubt, but even the Pollyannas agree that the day will come when Beijing no longer feels constrained by a need to force feed its export sector in order to absorb unemployed rural workers. Granted, that point might not be reached for another 20 years, but we also know that the domestic COSTS of BWII will rise over time as well. If you accept Brad and Nouriel’s analysis, and I generally do, then those costs will probably rise quite steeply as we get into the out years of their 10-year soft landing scenario.

    So you have a line (the marginal utility of China’s dash for export-led growth) gradually coming down, and another line (the marginal DISutility of BW II) gradually – and maybe not so gradually – rising. Eventually, the two lines will cross, and this could well happen before the adjustment process is complete (assuming, of course, that there is even going to BE an adjustment process, which is actually pretty dubious, at least before January 2009.) At that point, Beijing’s long-term strategic intentions presumably would become determinative.

    Or to put it another way, is China to America was America was to Britain in the late 19th century – i.e., a rising long-term partner? Or is China what Germany was to Britain in the late 19th century – a rising long-term rival for hegemony?

  • Posted by anne

    “[I]s China to America what America was to Britain in the late 19th century – i.e., a rising long-term partner? Or is China what Germany was to Britain in the late 19th century – a rising long-term rival for hegemony?”

    I believe we are historically appreciative enough of each other to work toward partnership. But, again, you are asking questions of prime importance no matter the answers struggled for. Thank you for such thoughts.

  • Posted by glory

    http://quote.bloomberg.com/apps/news?pid=10000039&sid=adHxnK7X0RB4

    Who’ll Be James Dean of Dollar’s ‘Chickie Run’?
    by Andy Mukherjee

    From a social perspective, however, there’s a better solution: Get an adult to break up the game. There’s no world government. So the next best option is, what Oxford University economist Brad Setser calls, an “Asian Plaza” accord, similar to the 1985 agreement drawn up in New York’s Plaza Hotel whereby Japan and Germany, France and the U.K. agreed to let an overvalued dollar decline.

    Even Morgan Stanley’s chief Asia economist Andy Xie, an advocate of the “Asia-must-fight-back” strategy, is calling for a negotiated settlement with the U.S., though he doesn’t favor an increase in the value of the Chinese yuan. According to Setser, substantial appreciation in Asian currencies will be the cornerstone of a new Plaza-style agreement.

  • Posted by glory

    http://quote.bloomberg.com/apps/news?pid=10000039&sid=acH5RHbiRdAQ

    Cheap Money Trumps Sea of Negatives for Bonds
    by Caroline Baum

    If you had told a roomful of bond traders one year ago that the dollar would plummet, commodities would soar and inflation would rise in 2004, not one of them would have predicted that the 10-year Treasury note yield would end the year within a hair’s breadth of where it began it, at 4.25 percent.

    [...]

    What happened to the higher expected yields that weren’t? One frequent answer is massive Asian central bank buying of Treasuries from countries that intervene in the foreign-exchange market to prevent their currencies from rising (Japan) or that acquire dollars from exporters who can’t convert them in the open market (China).

    While China grabs all the headlines, as of October Japan held $715 billion of U.S. Treasuries, a 40 percent increase from a year earlier. (The Treasury statistics on foreign holdings include both official and private investors.) China, whose trade surplus with the U.S. ballooned to $131 billion in the first 10 months of the year, increased its holdings by 16 percent to $174.6 billion.

    The hole in that argument is that foreign central banks traditionally park their dollars in the short end of the yield curve, according to Jim Bianco, president of Bianco Research in Chicago.

    “Financing rates are more important to bonds than the inflation rate.” [Bianco says]

    Easy money since the Sept. 11, 2001, terrorist attacks has encouraged “a new breed of leveraged investor, with most of the hedge-fund growth coming in fixed-income arbitrage or relative value funds,” Bianco says, based on data from Hedge Fund Research in Chicago.

    The growth in hedge funds is also evident from the explosion of trading in U.S. stocks and bonds from the tax-haven countries of the Caribbean, where total turnover is up 100 percent in the past year, according to Bianco.

    If cheap money has been the inducement for hedge funds to load up on 10-year notes, then higher real rates should be the trade’s undoing. With core CPI up almost as much as the funds rate this year, there’s been no change in the real cost of financing bond purchases so far.

  • Posted by brad

    It does seem nouriel and I are read by Bloomberg’s Asia based columnists — the virtue of writing for what once was the Asia crisis home page!

    Alas, while Setser thinks a substantial appreciation should be the cornerstone of a new Plaza, he also doubts whether either the US or Asia is willing to do such a deal …

  • Posted by Dave L

    I haven’t seen much consideration given to the fiscal costs of China’s dollar buying. Colleagues of mine who follow monetary policy there more closely than I do report that the PBOC only began sterilizing its dollar purchases at the beginning of 2004, which helps explain the very rapid growth of monetary aggregates before that. Now the authorities are finding that sterilization is already saddling the government with a lot of interest expense, AND putting substantial pressure on domestic rates.

    This, to me, is the key difference with Japan – which was in the position of being able to conduct unlimited intervention without having to sterilize. China, on the other hand, can’t avoid worrying about the inflationary consequences.

  • Posted by anne

    http://www.nytimes.com/2004/12/24/business/worldbusiness/24china.html?hp=&pagewanted=all&position=

    In Roaring China, Sweaters Are West of Socks City
    By DAVID BARBOZA

    DATANG, China – You probably have never heard of this factory town in coastal China, and there is no reason why you should have. But it fills your sock drawer.

    Datang produces an astounding nine billion pairs of socks each year – more than one set for every person on the planet. People here fondly call it Socks City, and its annual socks festival attracts 100,000 buyers from around the world.

  • Posted by anne

    http://www.nytimes.com/2004/12/24/business/24hedge.html

    Hedge Funds, Once Daring, Trim Their Currency Bets
    By RIVA D. ATLAS

    The fall in the dollar this year has been severe – the currency reached a low against the euro yesterday – but few of the best-known hedge funds have made a killing off the dollar’s decline.

    That is a big change from years past, when the largest hedge funds made or lost fortunes by gambling on shifts in currencies. George Soros made $1 billion for his investors by anticipating a decline in the British pound in 1992, and Julian H. Robertson Jr.’s funds lost $2 billion in a single day in 1998 after betting the wrong way on the value of the yen against the dollar.

  • Posted by anne

    http://www.nytimes.com/2004/12/24/business/24hedge.html

    Hedge Funds, Once Daring, Trim Their Currency Bets
    By RIVA D. ATLAS

    To be sure, some investors have made a fortune by betting against the dollar in 2004, including Warren E. Buffett, the chief executive of Berkshire Hathaway.

    “In 2002, we entered the foreign currency market for the first time in my life,” Mr. Buffett said in a letter to Berkshire investors in last year’s annual report, “and in 2003 we enlarged our position as I became increasingly bearish on the dollar.”

    Berkshire owned $12 billion in foreign currency contracts at the end of last year; by the end of September, that had increased to $20 billion. It reported a $412 million gain on those contracts in the third quarter, reversing a loss from the quarter before.

  • Posted by anne

    http://www.nytimes.com/2004/12/24/business/worldbusiness/24steel.html

    Steel Shortage Squeezes Asia’s Manufacturers
    By TODD ZAUN and WAYNE ARNOLD

    TOKYO – It has been a long time since Japan has experienced shortages of any kind. So it came as something of a surprise last month when Nissan Motor was forced to briefly suspend much of its production because it could not get hold of enough steel.

    Since then, Suzuki Motor has said a lack of steel would force it, too, to shut down assembly lines for a few days this month, and to reduce production from January to March. Even the giant Toyota Motor said Thursday that it has had to make adjustments in the kind of steel it buys to ensure steady supplies.

    The shortfall in steel is unusual in a country that for most of the last decade has been dealing with problems of excess – too many workers, unused plants and more banks than needed – but analysts and executives say it is a problem that could become increasingly common.

  • Posted by brad

    DL — nice comment.

    two other points: One, I think the story in Japan is a bit more complicated, simply b/c the MOF is financing the intervention (and issuing yen bonds to do so) and the BOJ is running monetary policy (i.e. buying yen bonds for yen to increase the money supply), but the basic point holds — the MOF issues bonds at 1% to buy bonds at 2, 3 or 4% — depending on where they end up on the curve. The carry is at least positive.

    In China, your timeline on stepped up sterilization is consistent with the data in Higgins and Klitgaard (NY fed, 2004). The fiscal costs are a concern for three reasons: one, it is pretty clear, tho it has yet to be confirmed in China’s reserve data, that the pace of inflows into china picked up in q4; two, with slightly higher domestic interest rates, the carry (gap between domestic and $ interest rates) must be negative; and three, at least with China, there are long-term fiscal cost associated with holding so many $ assets, since over time, the renminbi is sure to appreciate substantially v. the $ (see $ v. pound over time, see yen v. $ in 60s, 70s, 80s, etc).

    Of course, China cares about many things (BW2 proponents say china cares more about using export growth to spur fast overall growth) , not just potential fiscal losses on the PBOC’s balance sheet. But my sense is that they are starting to worry about the scale of their potential losses …

  • Posted by glory

    re: hedge funds

    yes, the major trend of the year (besides the oil and some of the commodity runs) is the dollar’s decline. if CTA (managed futures) hedge funds and prolly most multi-strategy hedge funds aren’t in on the trade, i’d be surprised. esp becuase central banks are willing buyers.

    in other markets traders have to worry about the trade becoming one-sided. if everyone is short there’s no one left to sell to. not so on a lot of dollar crosses.

    http://www.wachovia.com/ws/econ/view/0,,2233,00.pdf

    there’s a great chart on page 3 showing the C/A deficit vs. private capital inflows. the crossover in late-2002 proximately marks the beginning of dollar weakness.

    http://federalreserve.gov/releases/h10/summary/indexn_m.txt

    BUT, i don’t care so much about dollar weaknesss per se (“orderly” dollar weakness *should* help alleviate the trade deficit, as roach has sed) as i am about inflation and rising long rates (that could quickly make things “disorderly”), which is why i’m concerned with what bianco is saying.

    if it’s true that “most of the hedge-fund growth [is] coming in fixed-income arbitrage,” then as i mention in delong’s post…

    http://www.j-bradford-delong.net/movable_type/2005-3_archives/000042.html

    as the fed raises rates and takes away the “cheap money” they’ve been using to go long and buy 10-year notes, there’s a point where the fed takes the curve away (the yield curve becomes too flat to be profitable) and hedge funds exit the carry trade, which would in turn launch rates higher…

    note that if hedge funds really are sitting on the long-end living off the curve, it implies that long rates DO NOT presently provide an accurate gauge of inflation expectations.

    the result would make one of delong’s conditions for a soft landing, “if the rising long-term interest rates that diminish employment in construction and investment-goods production are somewhat delayed,” untrue.

    http://www.businessweek.com/magazine/content/03_05/b3818052.htm

    in which case greenspan and bernanke ironically may well end up buying long-dated treasuries afterall :D

    cheers!

  • Posted by gillies

    “Is China to America what America was to Britain in the late 19th century – i.e., a rising long-term partner? Or is China what Germany was to Britain in the late 19th century – a rising long-term rival for hegemony?”

    at best china is to america what east germany was to west germany. ex communist, source of cheap labour, bone-dry for soaking up investment, long term enrichment if you can wait that long and short term drain on resources of every kind. the two germanies have language and culture in common, and history – all but a few decades. the sino-american symbiosis has little in common between the nations except a massive potential for joint deflation.

    here is another one : america is to europe what the western roman empire was to the eastern roman empire. america is the rome – europe is the older but more resilient constantinople – the byzantine empire.

  • Posted by gillies

    on your bad days, friends, you consider everything from an american perspective. ( i mail this from ireland – and admittedly we have similar tendencies).

    on your better days you look at america / china from the chinese point of view, or america / japan from the japanese point of view.

    but the japanese might be assessing the consequences of a bond market crisis from a japan / china point of view – or china from a china / japan point of view.

    perhaps one asian rival is wondering what will happen if the other asian rival strikes first. the prisoner’s dilemma may be played out between these two actors. sino-japanese relations may thus be the key to the financial future.

    america, the greedy child, has had confectionary on credit from not one asian sweet shop but three or more. each sweet shop owner must wonder – what happens if one of the other shops refuses credit first ? would not that then be the worst of all outcomes for our particular shop ?

    any such crisis will stem from unilateral action. solutions will only come from multipolar co-operation. perhaps it is time to call for the cancellation of the debts of impoverished countries – including your own, the biggest of them all? and the agreed imposition of some financial discipline ?

  • Posted by Billmon

    “in other markets traders have to worry about the trade becoming one-sided. if everyone is short there’s no one left to sell to. not so on a lot of dollar crosses.”

    Which of course insures that over time the central banks WILL become the only ones left on the other side of the trade.

    Will Asian central banks become to the dollar what the Hunt brothers were to silver?

  • Posted by brad

    glory — nice comment. there are all sorts of interesting permutations on this. suppose the long end of the curve is being supported both by disguised buying by foreign central banks (not the BOJ acting for the MOF) and maybe some petrodollars as well as hedge funds borrowing short to buy long. then suppose Fed rises take the hedge funds out of the equation. The price of the long bond starts to fall in $ terms. Does the foreign bid step up, or dry up?

    billmon — we agree on too much!

    you hit the nail on the head here:

    “The number crunching exercises only highlight the overwhelming importance of a gradual adjustment, in which the arithmetic of compounding works for us, not against us. However, this will require the Asian central banks to continue funding extremely large U.S. payments deficits for many years to come – probably well past the point where a rational evaluation of their own narrow self interest (i.e. export market share) would lead them to pull the plug and cut their losses.

    It seems to me a gradual adjustment would require a hell of a lot of trust (an extremely rare commodity in international monetary relations.) The members of the Asian central bank cartel would have to trust each other not to cheat on their reserve policies (the prisoners dilemma problem.) And they would all have to trust the United States to stick with the adjustment program – rather than simply taking advantage of BWII to keep living the high life as long as humanly possible. I guess to a certain extent the Asians would also have to trust the Europeans not to lever the euro lower against the dollar AND the yen AND the renminbi, and trust OPEC not to completely decouple oil prices from the dollar (a lesser risk, I admit, but given Asian fuel bills, not one they can completely ignore.)

    My worry: every year Asia finances the absence of adjustment in the US reduces the odds that they will keep on financing us during the period of adjustment. If 2005 is another 2004 — with say $450-500 billion of central banking financing allowing the US to avoid starting to adjust, then Asian central banks may be less willing to provide the say the extra $300 billion needed in 2007 to avoid too rapid adjustment …

  • Posted by brad

    billmon, others commenting on the USA is to China as … thought thread.

    check this out:

    http://news.ft.com/cms/s/4626b21a-5514-11d9-9974-00000e2511c8.html

    I intend to do a full post on this at some later point, but this article i think highlights a set of contradictions in US China policy. The Pentagon sees China as a potential threat (We need to be so strong as to deter China from ever challenging us — the brass, rummy and the neocons all lean a bit in that direction from what i have read), so our allies should not be selling arms to China. The Treasury though relies on selling bonds to China (next year, China’s $ reserve accumulation will exceed Japan’s, and those $ are going somewhere, even if they are not showing up in the TIC data).

    Look at it fron Beijing. China is subsidizing the debt market of a country that is borrowing like mad to develop and build a new generation of new high tech weopans while also fighting a war in Iraq (viewed from Beijing, that probably seems like putting iraq’s future oil along with saudi arabia’s future oil in a “no go” zone for Chinese firms, who left investing in oil’s high cost periphery … ). Conversely, by keeping the exchange rate low and chinese labor cheap, China is creating a huge incentive for western firms to transfer civilian high-tech know-how to China –

    Makes for a complicated stew

  • Posted by Billmon

    “Makes for a complicated stew”

    Indeed. Of all the major players in the game, the Chinese are the hardest to read – in part because of the traditional inscrutibility of the Middle Kingdom to us barbarians, and in part because it’s hard to see where their long-term interests actually lie.

    For example, does China’s leadership see the U.S. security presence in the Middle East and its control of the international sea lanes as safeguarding China’s access to Persian Gulf oil – protection China itself can’t provide, since it doesn’t have a blue water navy? Or does Beijing regard it as a potential stranglehold on its long-term energy security — much as imperial Japan came to regard western control of the Indonesian oil fields in the years before World War II?

    It may be (and of course I’m only guessing) that Beijing sees U.S. hegemony as a necessary – if uncomfortable – short-term evil, one which permits China to focus on its rapid growth strategy until it has the wealth and technology to stake its claim to at least regional predominance. (Just think of it as a kinder, gentler version of the Greater East Asia Co-Prosperity Sphere.) They may not be worried much about the U.S. drive for advanced military technology, since they assume they’ll get their hands on it eventually, one way or the other.

    I do wonder, though, whether the increasingly reckless and out-of-control nature of American economic policy – and foreign policy – might not cause Beijing to reevaluate its timetable, and sooner rather than later.

    As much as the Chinese might prefer another decade or two of forced-draft, export-led growth and strategic partnership (or at least non-confrontation) with the United States, surely they can see how rapidly the costs of BW2 are going to climb unless the USA takes a radical turn towards domestic austerity very soon. I suspect their understanding of our political system is about as poor as our understanding of theirs, but do they REALLY think that’s going to happen? Do they still think they’re dealing with Bush the Elder and the GOP grown ups?

    Probably they’ll temporize – like the Europeans did in the latter years of BW1. They’ll go for a limited, controlled reminbi revaluation – 10% of something like that – and hope it buys them some time to diversify their reserves and lay the groundwork for the construction of a new intra-Asian monetary system.

    Will the Japanese go along? Beats me. But in the end, I do think it is China that will finally pull the plug on BW2, a move which will likely be accompanied by a major acceleration in Chinese defense spending and shift in Beijing’s foreign policy orientation – away from the USA (obviously) and towards Europe and possibly Russia.

  • Posted by brad

    Billmon — we still agree on too much. I too expect there to be lots of temporizing in 05 — a small renminbi revaluation and perhaps a basket peg, much more stringent efforts to limit capital inflows into China, etc. I doubt China is naive enough to really believe that Bush the younger will control spending enough to bring the deficit down substantially — but no doubt the talk is intended partly for their consumption (and for the US domestic bond market). It will take some time before Congress’s likely unwillingness to cut nondefense discretionary spending and the costs of an escalating war (Pete Peterson has noted that our all volunteer military is an amazing fighting force, but does not cheap … there will be a sup with $ for lots of amourmed trucks/up armoured humvees for the guard) make it clear that we have a 3-4% of GDP structural deficit, 4-5% without social security.

    China presumably has few illusions about its ability to influence US policy so long as it is not willing to use its high cards (its reserves) and force a crisis, but they do care about the pace at which they are financing the US. It has not been confirmed on the PBOC’s web page, but end Oct. FX reserves were reportedly $540 billion — up $25 billion plus over end Sept. That gives you quarterly reserve accumulation numbers of 30, 30, 45 and 60 plus in q4 (if october data is confirmed and continues, netting out likely valuation changes) — the trend makes the PBOC uncomfortable. That would put end of year PBOC reserves at 575 billion, plus say $10 billion in valuation gains or $585 billion …

    And don’t forget Korea. Its reserves are now confirmed up $40 billion this year, from 155 to 196 (as of mid December). And the pattern of increse is interesting — up $20 billion til the end of Sept (first three quarters), up $20 billion in the fourth quarter — and the won appreciated over that time frame.

    see:

    http://rki.kbs.co.kr/english/news/news_detail.htm?No=21519

    The “costs” of keeping BW2 alive are not constant: they escalated in q4 in ways that must make non-Japan emerging Asia uncomfortable. Japan spent so much defending the yen in 03/04 that they have been able to defend 100 on the cheap this time around …

  • Posted by spencer

    Billmon & Brad — great comments, however to go back to Wolfs origninal point that the deficit has to only go back to 3% of GDP. There is an unstated assumption in most comments that the
    US has to eliminate the current account deficit
    completely.

    But Wolf is saying it only has to go back to 3%, and there is a valid argument behind why I expect he is saying 3%. If the dollar is the world reserve currency there is a need for the
    US to provide reserves to the rest of the world –remember back in the 1950s and 1960 when the issue was a dollar shortage because of this.

    It looks like Wolf is assuming that the world needs a US deficit of around 3% to provide sufficient world liquidity and that assuming that the goal should be completely eliminating the deficit significantly overstate the size of the adjusment that is needed.

  • Posted by brad

    spencer — fair point. but i would argue the magnitude of the deficit the us needs to run to supply world liquidity is more like 1% of US GDP, not 3%.

    wolf’s 3% current account deficit falls out of a scenario where the US external debt to GDP ratio stays constant, not out of an estimate of the world’s ongoing demand for an increase in dollars to lucricate a growing world economy. before 2002, the world’s demand for dollar reserves was in the $100 billion a year range — sometimes a bit less, sometimes a bit more — or about 1% of GDP. That seems to me to be roughly the need associated with dollar’s reserve currency status.

    A 3% of GDP deficit will meet all the demand for higher reserve holdings, and then require we attract a bit of additional private capital to finance the ongoing deficit.

  • Posted by Guest