Latest speech of FRBNY President Tim Geithner
I pay a certain amount of attention to what New York Federal Reserve President Tim Geithner has to say just because he was my boss at the Treasury and the IMF (noted in the spirit of full blog disclosure). But he also has just about as much experience dealing with financial crises as anyone — almost as much as Stan Fischer.
His most recent speech warns market participants and policy makers alike of the danger of not taking advantage of good times to build buffers and shock absorbers that can help cushion against unexpected risks. That is a lesson emerging economies learned the hard way.
But today, perhaps the biggest risk out there — as Geithner notes — is the risk that the market moves required to correct major macroeconomic imbalances (i.e. the US current account deficit) may be large and abrupt, not small and undisruptive.
In the financial markets, this broadly positive outlook has been accompanied by a dramatic reduction in risk premia, leaving the price of insurance unusually low against a less favorable or more volatile environment. These developments imply a view among market participants that future macroeconomic shocks will be more moderate than in the past and more likely to be absorbed without broader damage to economic performance or the financial system … they imply that the imbalances in the global economy will be diffused smoothly
A bit further along Geithner notes:
This combination of fiscal sustainability problems, large external imbalances, and the tension in the existing exchange rate system creates the risk of unanticipated shocks to financial prices, even in a context where monetary policy credibility is strong. The probability of these shocks may be low, but it is higher than it has been, and higher than we should be comfortable with.
Like Delong, I would put more emphasis on “higher than we should be comfortable with” than on “may be low.”
What steps does Geithner suggest to protect ourselves against this set of risks.
1) Take advantage of the “unusually low price” of insurance. After all, low prices can reflect an absence of sufficient demand for insurance.
Consider one example: the US Treasury. It could insure against a rollover crisis — or against the more probable risk of significantly higher short-term interest rates — by lengthening the average maturity of its new Treasury issuance. 4.2% nominal for ten years is not bad! But issuing ten year Treasury notes rather than two year or five year Treasury notes means slightly higher current borrowing costs. It also runs against the current de facto policy of keeping the supply of ten year notes tight to help keep the 10 year rate low … See this Roubini post for all the gory details of recent US debt management.
Or consider the use of interest rate swaps by corporations who issue long-term fixed rate debt and then swap their long-term debt into short-term floating rate debt to save a bit of money — and old Bill Gross concern relayed by the Capital Wire. This may note be as prevalent today: “curve flattening” (the reduced gap between short-term and long-term rates) should be making this kind of trade less attractive. But no doubt there are other examples out there.
2) Borrow less. Geithner warns: “the present fiscal trajectory entails an uncomfortable scale of borrowing and little insurance against possible adverse outcomes in an uncertain world.” I presume the reference to Rubin’s In an Uncertain World will not be lost on many in the Bush Administration, nor will the implicit call for a Rubinesque policy of limiting US borrowing in good times, to better prepare for bad times. No disagreement here.
The US is on track — using realistic assumptions — to run ongoing fiscal deficits of around 3.5% of GDP even with steady, sustained growth, and thus has no fiscal “buffer” against worse than expected outcomes: an interest rate shock that increases the government’s borrowing cost, a recession that reduces tax revenues, a more expensive than expected war …
One small point of disagreement. Geithner — like most — recognizes that current account deficits of 5-6% of GDP cannot be sustained indefinitely: the real debate right now is over how long those deficits can be sustained. Geithner, though, argues the flexibility of the US economy may allow a relatively painless adjustment (a Greenspan theme).
I am a bit less sanguine. The US has a fair bit of experience shifting resources (capital, labor) out of the production of tradable goods; much less experience shifting resources back into the production of tradable goods. Yet it is pretty clear that at some point, the US either has to export more, or it will have to import less — and the required change is large in relation to the United States small export base (a key point made by Rogoff and Obstfeld, among others)
But even if labor can be redeployed quickly and easily into “tradables” production (Some people who left Ohio for Florida might need to move back!), there are limits to how fast the United States’ capital stock can change. Consider how our existing capital stock constrains our ability to adjust to a different kind of shock – an oil shock. To paraphrase Rummy, when an oil price shock hits, you are stuck with the car you have, not the car you might want to have. Even if you want to dump your H2 in the used car market and buy a Smart car, someone else has to buy the H2. The auto fleet turns over, but not overnight. Even if all new car buyers opt for itsy bitsy fuel-efficient cars, there will be lots of SUVs in the American fleet for some time.
Similarly, when the US finds it has to reduce its imports to match its exports, grow its exports to match its imports, or do some combination of the two, it will do so with the capital stock that is being created by investment decisions being made today. The US will go into an external adjustment with its current export sector, not the export sector it might want to have.
My worry? I don’t think there is much evidence that current low interest rates are spurring a wave of investment in US export industries, or in industries that compete with imports (deciding not to offshore something already done onshore doesn’t help to reduce the US import bill … activities now done offshore need to be moved onshore).
Over the next five years, if you want a really big commercial airplane you won’t be able to by one from an American manufacturer. Or, more accurately, the American product will be somewhat smaller and based on a 1960s era design (admittedly, a great design, and one that has been updated several times). While Airbus is creating a brand new production line to expand its product range, Boeing is shutting down several of its older aircraft production lines, and the new line for the 7E7 is still some ways off.
Boeing-Airbus is just one example, and probably not the most typical, since Asia is not (yet?) a player in the commercial aircraft market.
More generally, though, the current pattern of investment is, in part, a byproduct of the distortions created by the Bretton Woods two system of central bank financing for US deficits. The implicit interest rate subsidy from Asian central banks spurs interest sensitive sectors, but Asia’s undervalued exchange rates discourages investment in sectors that currently compete with Asia, or will do so in the future. The result: plenty of investment in hard-to-export residential housing …
Another remarkable post, and most discouraging.
Ah, we are a service economy. Don’t you wish you were a service economy? So has gone the refrain for years. But, now we must consider that exporting Citigroup or Avon to China means investment and lots of employment in China but not much in the way of “exports.” There are earnings to the companies, but where are the exports? Then even though the dollar declines more against the Yen or Rupee, or declines at all against the Yuan, the effect on American exports will be limited. Imports then must fall to get to a better trade balance, and that means significant price increases for imported goods.
PREMIA wha’s wrong with “Premiums”. Next we will have a young man pluralizing it to “Premiae”, like “Agendae”.
This is the heart of the matter.
Is the foreign financed investment in US destined to increase its productive capacity or it is being wasted in (in soviet-era slang) unproductive investments? If this is the case, then there is no way of achieving a painless rebalancing.
The problem of rebalancing the American economy away from SUVs and Mcmansions to a export powerhouse is that there is not enough idle capacity nor human capital nor savings available to do that. And this is the case because the profit rate in the tradable sector is eons away from that prevalent in the non tradable sector. To achieve rebalancing to tradables you must first kill the non tradables. And this is a recession
Cheers…
We should all short the markets.
What are we waiting ?
Brad,
You said: “The result: plenty of investment in hard-to-export residential housing …”
But isn’t this precisely the US strategy? Create new expensive assets for which we trade goods and services? The rest of the world is clearly uninterested in our stocks, so we sell them our houses. Net agency bond sales to foreigners for the 12 months through October hit $218.5bn; in 2003 just $161bn. FDI into the US over the last four quarters (2003:IV to 2004:III) was $96.6bn; in 2003, a mere $29.8bn.
The US sells the means of production and the means of reproduction to foreign capital in exchange for goods and services. A profoundly short-sighted strategy indeed, but one which can work for a while yet I think.
Gen’l Glut
If it is true that we will need a big expenditure switch coupled with an equally big switch in production then there are going to be some truly big shifts in returns to various different assets. The people who own tradable producing capital and who work in those industries are going to win big. Those who own non=tradable capital (like houses) will lose big. There will be very big follow-on effects from these redistributions, especially if a large chunk of capital gets frozen up – e.g. if a lot of people end up with houses worth less than they owe on them.
I keep trying to think of a happier scenario for the future, but all the happy paths require me to believe things that are contrary to reality. Maybe that is Alan Greenspan’s real talent – He seems able to believe whatever he needs to.
The idea of a painless adjustment has always seemed fairly implausible to me given the length and depth of the imbalances and the fact that some of the key factors involved – like the decline in the U.S. personal savings rate – are big, secular trends that seem fairly impervious to macro policy adjustment.
If we’re very lucky, MAYBE the game can end like it did in the ’80s – with a partial soft landing followed by a relatively moderate recession. If there is enough unused capacity in the tradables sector (as there was during the 87-89 period) expenditure switching can work relatively smoothly, at least for awhile.
But the lesson of the late ’80s, it seems to me, is that expenditure switching alone will only take you so far. If the economy is anywhere near full employment, reflation in the tradables sector inevitably gooses domestic income growth, which boosts demand for both tradables and non-tradables, which gets the old wage-price spiral going.
If you’re the Fed chairman, this leaves you in a something of a jam, particularly if fiscal policy is on autopilot. If you tighten enough to offset the inflationary pressures created by the adjustment process, you not only run the risk of creating a recession, you’ll also probably cause the dollar to reappreciate, reversing part of the external adjustment. But if you DON’T tighten, the bond market will eventually geek out, as will the stock market. And the real exchange rate will appreciate, also reversing part of the adjustment.
That’s more or less how it played out in the 88-90 period, with Greenspan barely managing to keep the Reagan expansion airborne, at least until Saddam doublecrossed everybody and invaded Kuwait. The 90-91 recession brought the current account back to balance (with a little help from our Gulf War allies.) It was certainly painful, and at times scary, but it wasn’t Armageddon.
But so much has changed since then – not least politically – that it’s hard to see how the plane can be brought in for even a semi-soft landing now. As I argued in a comment over on the other Brad’s blog, it just defies plausibility to think that any of the parties involved (whether U.S. or Asian) are going to make the necessary adjustments before a full-blown crisis forces them to.
If only the world were so simple … exports are made possible by other nations allowing the flow of US goods into their countries … the reality is that China, Japan, Korea, Europe have material trade barriers to American products. Can the US export autos to Japan, Korea or China in a manner similar to their ability to export autos in the US? No … imports are strictly managed … this creates the incentive to push production abroad …
Our ability to export a number of products to China is contingent upon technology sharing … this is extortion …
The Europe has implemented a number of trade barriers to restrict US competition or move production to Europe … Electronic standards that differ from the US to import requirements that raise supply chain costs … a critical cost to exporting PCs.
If the US exported to balance trade we would have a material impact on China and Europe …
While I am sympathetic to the idea of building reserves for future shocks, it is unclear what this advice really means … Of course their should be reserves. The example of increasing duration appears questionable. Will this decrease or increase total risk? A strong case could easily be made that it can both increase and/or decrease risk. Thus, what risk are we seeking to manage?
Without intervention by the government the US will not materially reduce imports or increase exporting. This raises the question of what type of intervention policy we should employ. Not an attractive or free market conversation.
Brad,
This is so contradictory to your trade is good bs as to make one’s head spin.
But for trade deficits, we wouldn’t be in this position.
Billmon, could you please develop this part, I missed the argument :
“But if you DON’T tighten, the bond market will eventually geek out, as will the stock market. And the real exchange rate will appreciate, also reversing part of the adjustment.”
I thought, if the bond market and stock markets fall, it means investors move out of these markets, which means especially foreign investors
will move out and this will rather push the dollar further down.
So could you please explain. There’s a point I do not get.
“I thought,if the bond market and stock markets fall, it means investors move out of these markets, which means especially foreign investors will move out and this will rather push the dollar further down.”
I don’t think the behavior of foreign investors in response to a steep decline in U.S. asset prices is easy to predict, since it would also depend on other factors – not least being the relative performance of foreign markets. Presumably, with global markets being so correlated these days, a bear market in the US would be accompanied by bear markets overseas, which would reduce the relative attractiveness of foreign assets.
At some point, you have to assume that the combination of a lower dollar and a higher yields would make U.S. asset attractive to foreigners again. The question, of course, is how low U.S. asset prices and the dollar might have to go to reach that point.
My real point, though, was that higher relative inflation in the US would cause the real exchange rate to appreciate, which over time would tend to offset nominal depreciation.
Thanks for your reaction.
Agreed the US have a higher inflation rate now.
However
1 Asset markets in the USA have higher PER than everywhere else, so far as the dollar has fallen, stocks have risen, as posted elsewhere by jesse.
For a comparison, Euro stocks are still at half their 2000 peak. Of course the increase in US stocks might be related to the US growth, but if US growth is mainly an increased external debt effect …
If growth in the US is to fall and debt to be reimbursed… Probably asset prices will have to fall a lot before they become attractive.
2
The main hypothesis for the years ahead still remains deflation.
How asset prices may fall without creating a credit shrunk and deflation would be a mistery.
I tend to think that US inflation is also debt related. Suppress external financing, and there you have deflation.
If the aim is rebalancing, since that’s where we will end anyway in the long run, there is little risk of excessive US inflation.
This last made me think. Where would investors go if there were a “flight to quality”? (i.e. if ALL the markets are tanking and people are getting nervous in a systemic way) – Traditionally, they go to treasuries and I am sure that would happen again to some extent. However, if treasuries are the SOURCE of the problem (i.e. the US gov issuing too many of them and selling them to foreigners) then we are looking at a picture of inflation, devaluation and stagnation all at once. The first is a true killer for bonds. The second is (or ought to be) bad for dollar denominated assets. The third says stay away from stocks. So where does that leave us? If I want to fly to quality I go to a euro denominated bond backed by the German government. If interest rates are spiking then make that short German govt. paper. Looks like a sort of vicious circle.
And on the question of how low the dollar would have to go and how high the yields would have to go to make US assets attractive again, I have two observations:
- US interest rates are still low by historical standards and would remain low in real terms if inflation picked up
- Exchange rates almost invariably overshoot their eventual new equilibrium so the dollar could go quite a ways beyond where it is. This is even more true if the adjustments the depreciation is supposed to provoke dont happen very fast
http://www.nytimes.com/2005/01/18/business/worldbusiness/18hainan.html?pagewanted=all&position=
China’s Latest Capitalist Beachhead
By DAVID BARBOZA
SANYA, China – China’s leaders once tapped Hainan, this small sunny island off the southern coast of China, to be one of five experimental laboratories for capitalism. Hainan was supposed to compete to become a new Hong Kong, even a future Singapore.
But more than a decade later, even as China’s hot economy bubbles over with success in places like Shanghai and Shenzhen, Hainan is, well, still an experiment, like a lone laggard.
It seems as though this place, despite its postcard-perfect views and year-round summer sheen, might be called one of China’s earliest glitches on the road to capitalism, an isolated patch of somewhat undeveloped land that had once captured leadership attention, wads of cash and many talented Chinese wanting to strike it rich.
“How asset prices may fall without creating a credit shrunk and deflation would be a mistery.”
It’s possible to have falling financial asset prices without debt deflation. It’s even possible to have falling financial asset prices and a relatively high rate of consumer price inflation – the mid-’70s being a case in point. Falling stock and bond prices may hurt the asset side of the balance sheet, but inflation helps clean up the liability side. Hard assets – commodities, real estate – can do well in an inflationary environment, especially if real, as opposed to nominal, interest rates remain relatively low. And while home equity isn’t the 400-pound gorilla of U.S. household net worth that it used to be, it’s still pretty big. So consumer spending and investment doesn’t necessarily have to crater just because the stock market does.
That’s not to say it would play out that way now if the Fed decided to put full employment ahead of price stability. A lot has changed since the 70s – vastly more debt, vastly larger international capital flows, vastly more complex and “flexible” (to use Greenspan’s favorite word) financial markets. Whether that last would prove a blessing or a curse in a full-blown dollar crisis remains to be seen. Maybe the end result would be something that looks like ’70s stagflation, or maybe the whole house of cards would come tumbling down, I don’t know.
But it seems worthwhile to consider that as the owner of the world’s primary reserve currency, the USA is in the rare position of being able to inflate away its own debts, external as well as internal. If there is a way to squeeze some short-term benefits out of an inflationary monetary policy, you can bet the ruling party would be for it, no matter what the long-term cost. Would the Fed have enough backbone to resist?
http://www.nytimes.com/2005/01/16/weekinreview/16china.html
It’s Just Business, Nothing Geopolitical
By KEITH BRADSHER
HONG KONG — Shut up and keep buying.
Few countries are benefiting as much as China these days from the international status quo – and Beijing knows it. So, as American criticisms of China have shifted from human rights to the value of its currency and the aggressiveness of its trade practices, Chinese leaders have tried hard to keep the peace while exporting ever more.
China’s economy is doubling in size every 10 years, and personal incomes have been climbing steeply, especially in the cities. Trade with the United States plays a huge role in that growth, as investors around the world pour money into Chinese factories that make goods destined mainly for the American market….
http://www.nytimes.com/2005/01/18/opinion/18tues2.html
India’s Choice
For an AIDS patient in a poor country lucky enough to get antiretroviral treatment, chances are that the pills that stave off death come from India. Generic knockoffs of AIDS drugs made by Indian manufacturers – now treating patients in 200 countries – have brought the price of antiretroviral therapy down to $140 a year from $12,000.
That luck may soon run out. India has become the world’s supplier of cheap AIDS drugs because it has the necessary raw materials and a thriving and sophisticated copycat drug industry made possible by laws that grant patents to the process of making medicines, rather than to the drugs themselves. But when India signed the World Trade Organization’s agreement on intellectual property in 1994, it was required to institute patents on products by Jan. 1, 2005. These rules have little to do with free trade and more to do with the lobbying power of the American and European pharmaceutical industries.
One detail I’ve been thinking about is what exactly it is that we (i.e. U.S.) would be exporting in greater amounts in order to close the gaps. Because we are a wealthy nation, we are not going to close the gap through the export of low-tech stuff – the margin just isn’t there when compared with our cost of living. Hence the ’service economy’ comments above. The point I want to make is that investing in a service economy is materially different from investing in industrial manufacturing.
The challenge for non-industrial investment is in booking an asset on the balance sheet. If you bought a factory that makes widgets, then it’s easy. If you bought a factory that makes memory chips, and that manufacturing technology suddenly becomes obsolete, that’s a different story (example: Hynix). If your business is contracting with the memory maker and a computer maker, that is a far different story – you can book the contract, but is there any reason at all to expect that you will be able to roll the contract and remain in your high-margin business? (example: HK-based textile intermediaries, now under incredible pressure – I believe this was discussed recently in The Economist). It is hard to invest in the service economy and hi-tech because there is much less staying power in the assets. Compare what computer programmers are getting paid today vs. 5 years ago – truly night vs. day.
We all know that you can’t have greater expected return without greater risk. Why should our economy appear more stable than China’s, when we are in businesses which could go the way of the NASDAQ, and theirs will go nowhere, neither up nor down?
Now I will pose a very simple question: If you are a debt investor, would you prefer that the business take more or less risks? Standard theory says you tell them to take LESS risks, because your debt is safer. If you are a large central bank in Asia, and you are already sitting on a mountain of US gov’t debt, wouldn’t you rather that Americans just keep building reliable homes, instead of investing in a new wave of tech startups which could crater?
I know this is a total ramble and admit I don’t have things sorted out at all; really I just want to suggest that the qualitative differences between the US economy and its main creditors could be an important angle to examine.
Let us consider carefully the New York Times editorial on the proposed change in India’s drug manufacture laws. Several times I argued with John Rawls and Lawrence Kohlberg that setting ethical problems in rich and poor countries would provoke different solutions. Kohlberg would ask whether we might steal a drug to save someone dear to us were we too poor to afford the drug. I was always struck by the ethical choice not applying to people for whom life saving drugs were beyond stealing. What of southern Africa? Now here is indeed a profound ethical question in what should and should not be limits to sharing intellectual property as the property is amassed at increasingly different rates in richer and poorer countries.
Its easy to overestimate how much debt we can inflate away. It depends on the term structure of outstanding debt. Certainly we can reduce the real value of long debt already in foreign hands but as inflation picks up new debt accumulation will be shorter and shorter at the same time that interest rates rise to reflect the inflation that is happening. The more we use this channel to reduce our debt the less effective it becomes. But there is certainly some mileage in it yet, especially if we take into account what the exchange rate could do.
To P:
“The Europe has implemented a number of trade barriers to restrict US competition or move production to Europe … Electronic standards that differ from the US to import requirements that raise supply chain costs ”
I don’t get your point…
Seen from here, I was always thinking that US had implemented trade barriers to restrict european competition ,with those slighty different requirements for car or electronic ?
And by the way, trading only in that different money instead of Euro, the US-Dollar, they are also raising european costs to export in America
America
Billmon, the main difference with the 70’s is Labor bargaining power.
You can’t inflate your economy away from debt if wages lag behind productivity, let alone behind prices !!
The only way to raise demand when wages lag behind productivity is through more debt, therefore, inflation can not erase your debt in such a situation …
THe main problem of the world economy is wages remaining too low.
One reason of these low wages is excesive capital mobility and excessive labor market deregulation.
These will reverse in the next 20 years, you can bet on it.
[...] guess is that we will soon be bearing more about the need to build better shock absorbers into the structure of our financial [...]