Deficits really don’t matter, at least in some circles

Bush said earlier this week that he would not rule out paying those transition costs by raising the current wage cap of $90,000 that can be taxed for retirement.

“If you’re looking to rally the American people around a reform plan, you don’t lead off with a tax increase or benefit cuts,” Lessner said. “Those are both political losers.”

Texas sized private accounts (4 percentage points of payroll, once they are phased in), no tax increases (see Cheney’s remarks) and no benefit cuts until far in the future. That means lots of borrowing — if Social Security reform ever gets off the ground.

I have a more substantive post in the works, but I am still a bit surprised at just how fiscally unconservative conservatives now are.

The good capitalists at Morgan Stanley seem to think so.

Not all of old Europe has anemic domestic demand.

French (and Spanish) domestic demand is doing just fine …

And new Europe (sort of) Italy, run by Italian mogul (and Bush ally) Silvio Berlusconi, looks like schlerotic old Europe Germany. Both have lagging domestic demand.

So how can Germany become more like France?

Joachim Fels highlights one important difference. Housing prices are up in France, but not in Germany — even though one might expect low Eurozone interest rates would tend to boost the housing market, as in the US. I don’t know Europe well enough to know why low interest rates might have a different impact in France than in Germany, or whether there are policy steps Germany could take to spur its housing market.

But I am intrigued with the notion that Europe could take steps to increase the impact of relatively low interest rates on European consumption.

The standard US calls for Europe to implement ambitious structural reforms have never really appealed to me. On one hand, I do believe that national policy choices have global implications, and thus there is a role for coordination. Countries that grow below their potential drag down the global economy — just as countries that save too little and borrow too much reduce the global availability of capital to finance development. On the other hand, I also believe that different democratic societies will and should make different social and economic policy choices. Some societies will tend to want more risk to be assumed individually, and others will want to share some risks collectively. Most Americans think European societies assume risks that should be assumed by the individual; most Europeans think US society puts too many of the risks that should be assumed collectively on the shoulders of the individual. Fair enough. There should be some room for different nations to make their own choices — after all, the amount of risk that an indvidual member of a society shoudl expect to bear is a contentious issue within most countries (look at the debate on Social Security), let alone globally.

More narrowly, it is not clear that many of the standard set of structural reforms the US prescribes for Europe would have much impact on European domestic demand, particularly in the short-run. Any increase in investment from certain labor market reforms might well be offset by higher personal savings and less consumption. Certain structural reforms may indeed deliver long-run economic benefits, but they are unlikely to provide major short-term stimulus to global demand. Consequently, the global interest in some of these reforms as part of a coordinated effort to rebalance the world economy seems rather weak.

Just look at what is happening in Germany.

To quote Fels:

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The Wall Street Journal says everyone in the world would benefit from a dose of Cowboyeconomics. You know, exporting tons of debt, to support consumption growth well in excess of income growth …

Obviously, global equilibrium requires someone to lend the US the money it needs to run large deficits. Not everyone can follow the same strategy — the US can only export debt if someone else is willing to import it.

There is little doubt that central banks have been the big (net) buyers of US debt exports over the past two years. Cowboy economics is underwritten by the Japanese Ministry of Finance and a bunch of Chinese Communists (Ok, a bit unfair, but the People’s Bank of China is one of the United States most important creditors)

The big question is how much, if any impact, this is having on the market.

Opinions differ — both in the market place and on different pages of the Wall Street Journal.

Broadly speaking, those who argue the impact of the central bank bid is overstated make the following points.

Treasuries rallied in December, despite a sharp fall off in foreign purchases of Treasuries.

Foreigners (mostly foreign central banks) may hold over 50% of all outstanding Treasuries, but their holdings tend to be concentrated at the short-end of the curve, and they are primarily price takers, not price setters. The market price is set here in the US, by the actions of American institutions who buy and sell Treasuries like mad. The yield of the ten year bond is determined by the willingness of American investors to hold the ten year rather than some other asset.

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That, by the way, would be a bit of a blow for Nouriel Roubini and myself — not just Dooley, Garber, Folkerts-Landau. Nouriel and I argue the Bretton Woods 2 of central bank financing of the US current account deficit will come to an end sooner rather than later. But we also argue that the end of central bank dollar reserve accumulation will have a significant impact on financial markets.

We don’t know China’s January reserve accumulation (yet), but reserve accumulation by ten other emerging economies (The Asian NICs, Thailand, Malaysia, India, Russia, Brazil, Mexico) is way down in January. After an average increase of over $35 billion a month in new reserve accumulation during the course of q4, the reserve of ten of the largest emerging economies increased by less than $2 billion in January. No doubt, the fall in the euro, which reduced the dollar value of their euro reserves, masked a slightly higher pace of new reserve accumulation. Still, there was a signficant fall in the pace of their reserve accumulation.

My provocative headline (for some) aside, this is a long, geeky and data intensive post — my apologies. This is important stuff, but probably not of general interest.

Let’s assume that China’s new reserve accumulation in January was $20 billion — A bit slower than in q4, but still a $240b annual pace. Shifts in the euro/dollar subtracted $8 billion from china’s reserves — so total reserves went up by $12b. Suppose the other ten countries also lost $8b because of shifts in the euro/dollar; their underlying pace of reserve accumulation then would have been around $10b.

Then reserve accumulation by eleven of the biggest emerging economies — countries whose central banks hold a bit under 50% of all central bank reserves and over 60% of non-Japanese reserves — totalled about $30 billion in January (with $16b in offsetting valuation losses). That is well off the average pace of monthly pace of $68 billion of q4, but that pace includes valuation gains from the rising dollar value of these countries euro reserves. Net out valuation gains, and reserve accumulation by these 11 central banks was probably about $60 billion a month in the fourth quarter — still well above my $30 billion estimate for January.

Yet, as we all know, long-term Treasury bonds rallied and Treasury yields fell in January. Not very good supporting evidence for thesis that Asian central bank demand has helped to keep Treasury yields low.

What is going on?

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John Plender of the Financial Times has a nice (subscription only) survey of the risk that “systemic risk” (think LTCM/ 1998) may make an unwelcome comeback.

Plender’s analysis clearly draws on New York Federal Reserve President Tim Geithner’s recent speeches. It certainly seems that Geithner is assuming the role of bad cop (Don’t forget about systemic risk, avoid “sustained fiscal and external imbalances that increase the risk of large macroeconomic shocks”) while Greenspan generally is more comfortable playing the role of good cop (Advances in financial technology make higher degrees of leverage safe) — though today, he too seems intent on warning against excessive complacency.

Plender makes an important point:

As short-term rates rise, and long-term rates fall, the “carry” shrinks. The same is true when credit spreads fall. Getting the same return, therefore, can require more leverage.

“The snag is that, since the Fed started to raise rates last Hune, the margin has become thinner. To achieve the same profit, people are taking on more leverage and making bigger bets. This makes for more volatile markets … Yet financial institutions continue to set targets for high and increasing revenues and profits that assume the good times spawned by freakish monetary policy will continue to roll.”

Sounds right to me.

Someone clearly has been making big, and I would assume quite leveraged, bets that the Treasury curve will flatten — though perhaps right now the trend is to take profits on this trade rather than to up the basic bet. No doubt there are other big leveraged bets out there as well.

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2004 US exports of debt securities: $890 billion

2004 US imports of debt securities: $2.3 billion Balance of trade in debt securities: $888 billion

2004 US exports of goods and services : $1146 billion

2004 US exports of goods: $808 billion. The US clearly has a comparative advantage selling debt to the world, and it is currently exploiting that comparative advantage to the maximum extent possible …

The mystery of China’s reserve management deepens.

According to the Treasury data, foreign central banks provided the US with $10 billion in financing in December, mostly from the purchase of $7 billion of longer-term treasuries (Actually, if you delve into the data, total official holdings of all Treasuries, bills and notes, fell by about $4 billion in December, as holdings of short-term bills dropped more than holdings of long-term bonds increased). Most of the $61 billion in net financing the US obtained in December seems to have come from private investors abroad, who bought $73 billion worth of US debt and equity securities(US citizens bought $21-22 billion of foreign debt and equity).

One problem: the Treasury inflow data does not square with the data on global reserve accumulation. We know China’s reserves, for example, increased by $36 billion in December. The dollar fell by about 3% against the euro in December, so even if China held $200 billion in euros, valuation gains only explain $6 billion of that increase ($200 billion is almost certainly too high of an estimate; in my most recent paper with Nouriel we estimated China’s non-dollar reserves to be closer to $155 billion, but we don’t really know). That leaves $30 billion in new reserves to invest. Most of that, presumably at least two-thirds, went into dollar assets — that implies the People’s Bank of China’s dollar holdings went up by around $20 billion.

That is more than the $10 billion in total official inflows in the December data, let alone the $2.7 billion increase in Chinese holdings of long-term Treasuries.

So what did China do with its growing reserves? Buy Treasuries through London broker dealers? Buy Agencies through intermediaries (foreigners bought $25.6 billion of agencies in December)? Buy corporate bonds through intermediaries? Build up its dollar deposits in the international banking system in the way that Japan did when it was intervening like mad at the end of last year? It clearly did something, and equally clearly, that something is not showing up in the broader US data.

The same point applies to the 2004 data.

We know foreign central banks reserves went up by about $700 billion in 2004, and that roughly $620 billion of that comes from new reserve purchases, not valuation gains. The TIC data recorded $236 billion of foreign central bank purchases of long-term securities (the vast majority of these purchases came from Japan; since the TIC data clearly is picking up BOJ purchases of Treasuries).

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Nouriel and I went out on a bit of a limb in this paper.

Since the beginning of the year, the dollar has rallied and yields on the ten-year and thirty year treasury bond have fallen: both market moves suggest that the US is not currently having any difficulty financing the US government’s $425-30 billion estimated FY 05 budget deficit (including the costs of fighting wars in Iraq/ Afghanistan), and the US is not currency having difficulty financing its roughly $60 billion monthly trade deficit/ $700 billion plus annual trade deficit. So long as the dollar is strengthening and US interest rates are low, the market is hardly sending a signal that the US needs to cut back. Nouriel and I argue this really is too good to last, and lay out the reasons why the US will be forced to cut back before the end of 2006. Put differently, we argue that while US might be able to finance external and budget deficits of the current scale at current interest rates and exchange rates for a few more months, it won’t be able to do so for two more years.

The value of this paper is that it forced us to lay out our assumptions. Hopefully, it will force those who think deficits of the current magnitude can financed and therefore both policy makers and the markets can continue on their current trajectory to lay our their assumptions as well.

Realistically though, not too many people will want to read the entire paper. Nouriel provided a brief summary of the paper earlier, but I wanted to chime in as well and provide my own guide to the paper’s highlights.Over the past two years, the US has financed a cumulative current account deficit of about $1200 billion. ($530b in 2003, $650 b in 2004). It has done so, in broad terms, by placing about $950 billion in debt with foreign central banks, and by getting about $250 billion in financing from the private markets. Our estimate for the amount of financing that foreign central banks provided the US in 2004 by adding to their dollar reserves is now $475 billion, a bit higher than the $400 billion that I have used previously.

There is no doubt that foreign central banks have provided the majority of the (net) financing the US has needed over the past two years, and have added to their portfolio of US assets at a far faster rate than foreign private investors. But the 950b/ 250b split between central bank financing and private financing also oversimplifies: foreign private investors hold more gross claims on the US can foreign central banks, so even if foreign central banks are adding to their claims faster than private investors, equilibrium still requires that foreign private investors be willing to hold on to their current claims (at current prices), rather than dump their existing claims in the market.

The actions of US investors also matter: if they want to increase their holdings of foreign assets, that would add to the United States aggregate need to attract foreign financing. For example, in 2003 and 2004, US investors bought more foreign stocks than foreigners bought US stocks, and US firms invested more abroad than foreign firms invested in the US. This resulted in a net equity outflow of $200 b in 2003, and an estimated $150 b in 2004.

Add this $350b net (equity) outflow to the $1200 b cumulative current account deficit of the past two years to get the total amount of debt the US needed to place abroad in 2003 and 2004: $1550 billion. Even if $950 billion of that was placed with foreign central banks, foreign private investors still had to buy around $600 billion of US debt for everything to work (foreign private investors have been buying significant quanitities of US corporate debt).

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We now know the trade deficit hit $618 billion for the year (5.35% of GDP)

Exports: $1146 billion

Imports: $1764 billionThe good news in December was the uptick in exports; the bad news was that the fall in oil imports did not produce a fall in overall imports — non-oil import growth continues to be strong.

Imports from China ($197 billion) exceeded imports of petroleum and related products ($175.5 billion)

That implies a current account deficit of $664 billion, 5.75% of GDP.

What about 2005?

First, assume imports and exports stay at their q4 levels through the entire year. Exports rise to $1181b; imports to $1868b, producing a deficit of $687 billion (5.6% of GDP). That produces import growth of 6%, export growth of about 3%.

Second, let’s assume that non-oil imports and exports grow at their 2004 annual rate, i.e. exports grow a bit faster than 12%, and non-oil imports grow a bit less than 15%. Further assume that oil import volumes grow by 5%, and oil averages $45 a barrel rather than $41 a barrel, increasing the US oil import bill by about $20b. That implies exports of $1287b, imports of $2020b, and an overall trade balance of -733 billion (6% of GDP).

Exports recently have been growing a rate closer to 10%, and non-oil imports should slow somewhat, so just projecting out 2004 growth rates is probably misleading. It seems to me more likely that, at least at the beginning of 2005, export growth may slow more than non-oil import growth, widening the overall deficit.

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Karl Rove is the Bush Administration’s economic policy czar, and de facto Treasury Secretary.

In addition to responsibility for political affairs and strategic initiatives, Mr Rove has been appointed deputy chief of staff to co-ordinate policy, both domestic and international.

Scott McClellan, the White House press secretary, suggested Mr Rove’s chief focus would be economic policy, domestic policy and international economic policy, leaving national security and intelligence to Joe Hagin, the other deputy chief of staff.

But Mr McClellan also made clear that Mr Rove’s promotion positions him to get involved in any and all administration business:

“Karl will continue to oversee the strategy to advance the president’s agenda. He will also co-ordinate policy within the various White House councils . . . the Domestic Policy Council, the National Economic Council, the National Security Council and the Homeland Security Council,” Mr McClellan said. The responsibilities will only add to the aura of Mr Rove, the most storied figure in the Bush White House

Good-bye Rubinomics; hello Roveconomics.

The basic political plan behind the current budget seems clear to me: generate enough of a fight about the FY 2006 deficit to give the Administration’s supporters grounds to argue that the Administration really is committed to limiting deficits. If the Administration is serious, and the FY 2009 deficit is forecast to be much smaller than the current deficit, it will be easier to convince Republican deficit hawks to sign up for the borrowing required to finance the partial privatization of Social Security. With W’s historical legacy secure, the real debate about the FY 2008 and FY 2009 can begin. In all probability, barring market pressure to cut the deficit, the structural gap between revenues and expenditures created by cutting taxes during a war will be squared by yet more borrowing.

The markets seem to be in a particularly forgiving mood right now, for whatever reason. The bond market rally continues, the dollar is up against most major currencies since the beginning of the year too, supposedly on the Administration’s new commitment to cutting the deficit. The markets seem to want to believe that global adjustment already has started happening, even if the Chairman is not quite as sure as he seemed on Friday. That way it is OK if the market moves in ways that take the pressure off the United States.

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