Brad Setser

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Robert Rubin still worries about the risk of a hard landing …

by Brad Setser
January 24, 2006

From Rubin's Wall Street Journal oped:

The effects of these fiscal conditions are exacerbated because they occur, uniquely in the U.S. amongst the developed nations, in combination with a very low personal savings rates, high levels of personal debt and enormous current account deficits (currently in excess of 6% of GDP, and caused at least in part by our fiscal deficits).

….  And the far greater danger is that these various imbalances could at some point lead to fear of fiscal disarray and concern about our currency, causing sharply higher interest rates in our bond markets and the risk of a sharp exchange-rate decline. ….  The adverse impact on interest and currency rates has not yet occurred, partly because business has had relatively low levels of demand for capital — but most importantly because of vast capital inflows from abroad (until recently, predominantly from central banks supporting the dollar to subsidize their exports). This is not indefinitely sustainable; at some point, which could be near in time or still some years out, continued imbalances, increasing fiscal debt levels and ever-greater overweighting of dollar holdings abroad are highly likely to lead to loss of confidence, and trouble.

There are lots of reason to worry about this scenario.  But one is that any reduction in foreign confidence in the US would undermine one the economy's key shock absorbers: the tendency of interest rates to fall as US economic activity slows, helping to moderate the fall in economy activity.

A savings "supply shock" that reduced the flow of global savings to the US could imply that US interest rates would rise even as the US economy slows.  The Fed would cut short-term rates in response to the slowdown, but foreign investors would not be willing to add to their dollar balances at those low rates.

The market would find an equilibrium:  policy rates might fall, but market (long-term) interest rates might not.  So a US slump might not lead to lower US rates.  Or in the worst case scenario, might be accompanied by higher long-term rates.

Remember, the US will still run a very large current account deficit even if the economy slows.   It will still need to attract very large flows of savings from abroad.   The price the US has to pay (the interest rate) to attract that saving matters.

There is an obvious analogy to an oil supply shock.   If higher demand leads to higher oil prices, that's one thing.  If demand falls, price should fall.   Rising oil acts as a brake on the expansion, and falling oil prices help soften any contraction.  Not so with a supply shock.   A supply shock can drive up price even as demand and activity are falling.   Or more precisely, a supply shock prices up the price, leading to a fall in demand and activity.

Thomas Palley is right:  "Foreign flight" (a shock to the United States ability to borrow savings from abroad) is very different from "Consumer burnout" (a slowdown in US demand growth).   In both the foreign flight and the consumer burnout scenarios, the US economy slows and the dollar falls.  But in the foreign flight scenario, as Palley notes, the fall in the dollar and rise in US (market) interest rates triggers the US slowdown, while in the consumer burnout scenario, the US slump triggers dollar weakness.    Foreign flight would combine dollar weakness with higher US (market) interest rates, consumer burnout combines dollar weakness with lower interest rates.   

Bill Gross sure seems to be betting on consumer burnout – driven by a slowdown in .home froth and home equity withdrawal.  

Actually, he seems to be betting that consumer burnout won't give rise to foreign flight.  Consider the following scenario.  Consumer burnout could cause the US economy to slow and the Fed to start cutting rates.  But as US rates start to fall, foreign investors lose interest in lending even more to the US.  Rather than adding $1 trillion or so to their portfolio of dollar denominated bonds at 4.5%, they want to add only say $600 billion or so … Reduced foreign demand for US dollar assets ends up pushing US interest rates up. 

At least those interest rates that are set in the market.  The Fed's response to consumer burnout could trigger foreign flight. 

That is a bad scenario. It implies that the US economy wouldn't benefit from some of the stabilizers that normally buffer the US from really bad (economic) outcomes.  

The risk of an oil supply shock that would keep oil prices from falling as US demand slows sure seems to be rising.  And underneath the surface, I suspect that the risk of a "savings" supply shock that would keep interest rates from falling even as the US economy slows are rising as well.


  • Posted by Navin

    India raised its interest rates today

    Brad – Does this mean the rupee is likely to inch up vs Dollar ? and shows that the central bank is not too keen on keeping the pseudo peg to dollar ?

  • Posted by HZ

    When Fed lowers policy rate, won’t US carry trade pull down the market rates even if there is foreign flight? That is the huge difference between borrowing in your own currency and borrowing in foreign currency. Foreign flight has to be severe enough to drive up domestic inflation so that Fed can’t lower policy rate, for your scenario to play out for a while. But then presumably domestic production will start to expand, eventually driving growth, so it is self-limiting.

  • Posted by Dave Chiang

    Unbridled credit expansion and asset inflation by the Federal Reserve in the United States are the direct cause of excessive consumption by American households and the near total loss of global competitiveness by domestic industries producing consumer goods. It is highly unlikely that the central banks of Japan and China will absorb another trillion dollars worth of monetary inflation from the US during the coming year. Leveraged Hedge Funds based in the Caribean are now financing 80% of the U.S. current account deficit. At the most basic level, Breton Woods II is a short-term vendor-financing scheme, capable of nothing more than buying time, which US policymakers appear intent on squandering.

  • Posted by Gcs

    brad u write
    “A savings “supply shock”
    that reduced the flow of global savings to the US could imply that US interest rates would rise even as the US economy slows”

    please explain possible
    sources of shock ???

    hz writes
    “When Fed lowers policy rate, won’t US carry trade pull down the market rates even if there is foreign flight? That is the huge difference between borrowing in your own currency and borrowing in foreign currency”

    explain to my feeble retired traders mind
    how in this instance carry trade counter flows arise strong enough to counter brad’s supply shock
    to me the tendency would be to exacrebate
    them least the fed kills both birds with
    a higher short rate to give a higher total return to the nasty hot specs
    then they will find availible over at any “flight to” currency

    and isn’t that brads point

    a forced fed hand

    leading to the horro of
    high policy rates
    and and and
    falling domestic demand

    i’m on to brad here

    he’s a smiling sadist

    trying to cook up
    one of those policy
    tit twisters
    like 70’s stagflation



    i must confess
    any time some one mentions
    uncle sam’s
    ability to borrow
    exclusively in his own currency
    i get a high

  • Posted by bsetser

    HZ — I’ll second GCS. exchange rate moves can easily wipe out a small dollr v. euro carry; plus, I would not rule out an ECB cut in a us/ global slump scenario.

    GCS — fair question on what would prompt the supply shock. a big change in the marginal asset allocation of Central banks or oil exporter’s investment funds is one. Or a general shift in the mindset of private market investors — from one where global imbalances don’t matter (morgan stanley macrovision conclusion) and bad things won’t happen to the US ’cause the fed won’t let them happen (macrovision) to a slightly less complacent view? either works. or a two step, with a shift in private portfolio preferences putting pressure on the $, more central bank intervention and eventually, central bank’s hitting their breaking point … you pick.

  • Posted by bsetser

    A. I plead not guilty. I have proposed a way out of the rabbit hole. I don’t repeat it in every post, but I do not think anyone who reads this blog would doubt that I am for:

    a) fiscal adjustment in the US, which will tend to slow US consumption growth, as noted

    b) faster consumption growth in key emerging economies, notably China and the oil exporters. and I have suggested a series of policy steps that would lead to faster consumption growth in China (social insurance, bigger fiscal deficits, upfront bank recap, etc) and faster consumption growth in the oil exporters (less gov. saving of oil surpluses, more distribution to the population).

    c) rebalancing the $/ emerging market exchange rate — with appreciation of the RMB, riyad and Ruble — supporting a general rebalancing global consumption growth.

    I have been pretty clear what I am for, and also how my prescriptions differ from the standard reblaancing scenario — compared to the average, i see greater potential to increase consumption in the emerging world, and for the emerging world to drive global demand growth, and I see less potential for structural reforms in europe to play a meaningful role in global rebalancing.

    Navin — your point comes in here — i want more emerging markets to be more like India. India has enjoyed strong consumption growth recently, and, low and behold, is now running a current account deficit! Navin — i suspect the central bank is worried about the pace of demand growth, but i will be interested to see if higher local rates = more inflows/ more reserve growth and the like. given how big a role portfolio equity flows play in india, it isn’t obvious to me.

  • Posted by Guest

    “And so Chicken Little will worry”

    The dismissal of Rubin, the greatest Secretary of the Treasury since Alexander Hamilton, as a Chicken Little is a statement that combines the utterly contemptible with the stark staring mad.

  • Posted by INTP

    Brad, regarding your “worst case” scenario of a “savings supply” shock . . . would your paper “A Balance Sheet Approach to Financial Crisis” with its four risks (maturity, currency, capital structure, solvency) be relevant here? And in general, would your balance sheet approach ever be applicable to the United States?

    For this doomsday scenario, besides the Fed cutting the fed funds rate to stimulate the economy while the market finding an equilibrium for long-term rates, what would be the other policy options? As a strawman, would it be possible (and smart) to inflate our way out of debt since it is all denominated in dollars?

  • Posted by a

    Fiscal adjustment? Oh you mean tax hikes or spending cuts. Who’s going to vote for that? And even if it did pass, then those actions are recessionary – not good for the U.S., and not good for the world economy.

    China and oil-exporters spend more? Other than planes and movies, what does the U.S. have to sell them? They’d both be happy to buy more European luxury items, but there’s a limit to that, too. Basically, they probably don’t want to spend more money on Western consumer goods.

    Exchange rate? Yes, but that would have to be really really significant to change things, and if it’s that significant, it’s going to be just as messy as what you’re worrying about in the first place.

  • Posted by bsetser

    INTP —

    It wasn’t just my paper — Christof Rosenberg, Christian Keller and I were equal partners in the effort. And balance sheet analysis is always relevant — I believe in it as much Rubin believes in fiscal discipline.

    But it is sometimes of greater use than in other cases.

    Because US external debt is overwhelmingly in the dollars, the US doesn’t have meaningful currency risk — so that part of the analysis can be dismissed.

    The US is very illiquid in some sense — so Short-term external debt v. US reserves and you will see what I mean. but that metric is not terribly useful for a reserve currency country. The US can always print dollars, as you note.

    The maturity structure of the US external debt stock is relevant for the “inflating it away” analysis — to extent that foreigners holder shorter-term claims, it is harder to inflate the debt away (actually, devalue it away, since devaluation is what matters from a foreign point of view, tho inflation usually leads to a devaluation). And to the extent that relatively speaking more long-term claims are held by domestic investors and fewer by international investors, inflation ends up having more domestic pain and less external pain.

    the US external capital structure is deteriorating — more debt, less FDI and the like. but it is hard to complain when a decent amount of that debt is long-term, fixed rate and in US dollars. it has certain equity like/ risk sharing qualities.

    As for potential policy responses, the obvious prescriptions for countries with large external deficits — cutting the fiscal deficit to increase national savings — applies. to the extent that it reassures creditors, it lowers long-term rates. and to the extent that there really is a constraint on how much the US can borrow from abroad, less government borrowing means more private borrowing and less crowding out. remember, in the hard landing scenario, government borrowing starts pushing up higher interest rates because their are limits on how much savings the US can suck in from the world and thus there is some crowding out.

    policy outside the US matters — it needs to counteract the negative wealth effect from a falling dollar on foreigners’ US assets (probably small) and to offset the weakness in global consumption from a slowdown in US consumption (probably big). balance sheet adjustment probably matters less than real adjustment, so to speak …

  • Posted by DF


    So far I agree that there is a “comic” double symetry, we have simultanously the absolute certainty that the US consumer can’t add forever to its debt related spending, and that China-asia can’t add to its lending related oil and commodities consumption AND that China-asia-oil countries won’t forever shift their savings to the USA and that oil fields are close to production peaks and other commodities close to such a situation.

    Aside from savings and spending :

    If we consider one single world economy we could simply say, without caring about savings and investment, that credit expansion (and debt based money creation) can not go forever at a faster pace than the world GDP.
    If i hold savings in an expanding economy through a series of asset bubbles caused by an expanding debt bubble … Then I will invest it.

    If I fear that this debt bubble is close to a top, then I will simply hold cash, deflation is the future.

    This I think is the correct situation of the global economy.

    Now as far as the USA are concerned, the choice wether to invest or not in the USA is related to the future of the US debt bubble. If I believe it will pop soon, I could well not invest in dollars and feel that the dollar is not indeed a currency, but an asset, whose price is bound to fall. It needs to pay higher rates.
    THe stake here is the status of the dollar as the hegemonic world currency.
    If the US loses its status as the hegemonic currency then it could cause a supply shock in foreign savings.

    If the US were a company, may be we could say that the recent rise in the dollar through continuous new acquisitions of reserves is a kind of speculative bubble.

    It would be interesting to know if may be something similar exists about rules. May be we could say that the continuous trend favoring rich people, globalisation and flexibility need now be reversed. It is very probable that such a reversal will completely alter the terms of the trade, the successful strategies, lots of things.

    Karl Polanyi rules.

    HZ, you write :
    Foreign flight has to be severe enough to drive up domestic inflation so that Fed can’t lower policy rate, for your scenario to play out for a while.
    I don’t understand how a foreign flight could drive up domestic inflation. THe way I see it, it would mean need for more taxes, bankrupcies and deflation. How can you see fleeing savings as a path towards inflation ?

  • Posted by Steve Waldman

    Brad, could you elaborate on this:

    “The maturity structure of the US external debt stock is relevant for the ‘inflating it away’ analysis — to extent that foreigners holder shorter-term claims, it is harder to inflate the debt away (actually, devalue it away, since devaluation is what matters from a foreign point of view, tho inflation usually leads to a devaluation). And to the extent that relatively speaking more long-term claims are held by domestic investors and fewer by international investors, inflation ends up having more domestic pain and less external pain. ”

    My intuition is the opposite: In the most extreme scenario, the Treasury can just redeem short term debt for zero-interest Federal Reserve notes or their electronic equivalent, which currency it receives from the Fed’s buying up short-term debt on the open market to drop interest rates. Long-term debtholders might take a special hit, in that presumably long rates rise as dollar depreciation becomes convenional wisdom, but this is a second-order and potentially reversible effect. It seems to me, a mercantilistic purveyor of monetary policy would be much more concerned about the percentage of foreign vs domestic ownership of claims than about the maturity structure of those claims. Am I missing something?

  • Posted by Elaine Supkis

    We handed our currency over to China and Japan with one proviso: we can arbitrarily set interest rates.

    China and Japan now have a death grip on our throats thanks to the high national debt. To keep this serviced, we have to please them and they are at war with each other, economically and probably militarily in the not too distant future.

    This doesn’t end with us buying lots of neat things at low interest rates. Or even being alive.

  • Posted by a

    “The dismissal of Rubin, the greatest Secretary of the Treasury since Alexander Hamilton…”

    I think you mean the greatest Secretary of the Treasury since Andrew W. Mellon.

  • Posted by HZ

    I was pointing to domesitic financial institutions playing carry trades along the yield curve. I don’t see how exchange rate is going to affect domestic carry traders such as the housing agencies. Plus US consumers are not shy from variable rate loans. Does anyone know where to find out the duration distribution of the treasury debt? Treasury presumably can shorten its average duration of new issuance as well. In summary I fail to see a scenario of Fed lowering short rate in conjunction with long rate going up, except when inflation expectation is going up which precludes Fed from lowering short rate in the first place.

    Foreign flight doesn’t really change domestic money supply, not directly anyway, since the debt are in USD.
    Presumably foreign flight, with sufficient severity, will result in a sharp drop of USD exchange rate, which results in higher import price and therefore inflation. But such a scenario also calls for expansion of domestic production and is therefore self-limiting.

  • Posted by HZ

    I guess you missed what gives GCS the high. Foreign savings in USD have only two ways of exits: 1) selling at a discount to some other foreigners, which results in a drop of USD exchange rate but does not change the aggregate foreign savings loaned to US; 2) buy US physical US products or assets.
    Both are inflationary, not deflationary.

  • Posted by bsetser

    Steve —

    The US federal reserve is independent of the US treasury, and the US treasury cannot create zero interest bearer Federal Reserve notes (i.e. cash). It could unilaterally restructure maturing t-bills into 10 year low coupon bonds, as some countries have done. But it won’t! the financial implications of that are truly unthinkable.

    What it will do is try to raise funds in the market to redeem maturing US treasuries. And that would drive up US rates.

    if short-term rates started to exceed the fed’s target, the fed would step in — and supply liquidity to the market.

    but foreign creditors might decide that the dollar holds more risks than they thought, and try to sell their existing dollar assets for dollars cash, and then dollars cash for euros, krone, s. franc, pounds or something else.

    and at some point the dollar’s fall would start to worry the fed (inflationary impact) and it would push up Us short-term rates.

    That would push down the price of longer-term US dollar denomianted assets, pushing up yields and the like. As would a desire to dump US assets to shift into euros or something.

    And some folks would be lending to lend the US treasury the funds it needs to refinance at a higher rate.

    you can tell different stories — but the key point is that the Treasury cannot create dollar liquidity, only the fed can. And in some circumstances, it wouldn’t. Its job is not to help the Treasury rollover its debt.

    Bottom line — short- maturity structure = quicker opportunity to demand an interest rate commensurate with perceived (currency) risk. hard to generate capital losses. long-maturity structure = stuck either selling or with a low coupon … and lots of potential for capital losses.

  • Posted by Not Gcs


    Could you please learn to type without pressing the Enter Key (new line) for every couple of words ?

  • Posted by HZ

    Agree Fed can’t inflate the debt away, not overtly anyway.
    The deficit pressure is inflationary not deflationary and the long rate is irrationally low. Thus I don’t see how Fed can lower short rate, even in the face of a domestic slowdown. Maybe that is what you are saying too.

  • Posted by HZ

    I guess what I am saying is that deflation and foreign flight are incompatible.

  • Posted by Guest

    “I think you mean the greatest Secretary of the Treasury since Andrew W. Mellon.”

    You do really need to seek professional help urgently. That and a decent education might even begin to turn your life around. Then again, probably not.

  • Posted by DF

    Hz have to disagree again.

    Let’s say foreigners indeed stop to lend to the USA (export savings), they indeed buy US products and also exchange dollars for other currencies, so that the US dollar falls.

    YOU say, well if they buy US products then growth and inflation, and if imports are higher then inflation again…

    Well sorry but you are thinking other things equal. I believe in the mean time, massive bankrupcies generate layoffs and a fall of imports, then foreigners have less surplus savings because they simply export less to the USA …

    I think you miss the main point, the global economy is in a bubble state and the global economy is heading with a 100% probability towards deflation.

    It is possible that deflation in the USA will turn smaller than elsewhere and you may call this “relative inflation”, but it is not inflation per se.

    The basic point remains this one : there are debt excesses debt excesses, asset prices excesses, commodity price excesses, and the solving of these exceses has almost come through deflation first.

    The FED has not prevented debt accumulation, how could it prevent debt destruction ? What do you expect exactly ?Do you think the debt/GDP ratio will reach heaven ? do you think it will plateau at the current level (even this would be very costly) ? Do you think suddenly one morning the fed will drop tons of cash to the consumers to erase past debts and undo 50 years of debt accumulation and 50 years of wealth accumation by lenders because suddenly it would have realised it has allowed too much debt creation ? Come on which of these solutions is plausible ?
    Debt deflation is our future. Globally.

  • Posted by Steve Waldman

    Brad. Thanks for the very thoughtful response.

    I suppose it depends on your degree of cynicism about the independence of the Treasury and the Fed. I’m not cynical enough to think the US will unilaterally restructure anything, but I do think it’s likely that, somehow or some other, the Fed will end up providing a lot of liquidity that, coincidentally, monetizes a lot of short term debt.

    As you say, you can tell lots of stories. A depreciating currency is inflationary, but not decisively so: Despite Wal-Mart, most of a consumer’s basket is still domestic. And (pace HZ), while the public deficit may be inflationary, defaults on private debt are both deflationary as a monetary phenonenon and diminish foreign appetite for US assets, consistent with dollar depreciation. Any US slowdown is world deflationary. Dollars may lose purchasing power more slowly than they depreciate against currencies and commodities. It’s not hard to construct a story where the Fed provides a lot of liquidity despite a depreciating USD.

    Thanks again for your always remarkable work.

  • Posted by INTP

    Thanks Brad! I am still NOT clear on the usefulness of balance sheet analysis for understanding financial crisis (as pertained to the US). It seems that when you went down the risks, I interpret your conclusion as nothing was really risky–maybe painful (e.g., the maturity mismatch risks of rollover risk & interest rate risk)–but certainly not of crisis proportions.

    What did I miss?

  • Posted by DF

    my last post got lost.
    thanks steve waldman I think you made many things clearer than I could.

    I mean to had this on after thought
    I think a supply shock in the supply of foreign savings is a wrong way to put things. It seems to imply that economies are close to equilibrium and moving around it.

    I think it is clearer to speak of a reversion of expectations. Suddenly the growth of the debt/GDp ceases to be an option, suddenly the growth of trade relative to GDP ceases to be an option.

    When you think of it the debt/GDP ratio is not very different to a P/E ratio. The earnings are the GDP, the debt is your valuation of future earnings… and no external shock is necessary to prompt a sudden reversal of the trend.

    It’s not foreigners not trusting the US, it the USA being the center of an economy completely out of touch with the main reality : too much debt around, this jeoparises future earnings.
    Too much has been done for lenders, asset holders, and too little for workers, for too long a time.

  • Posted by DF

    Brad aside from this post, do you think the RGE could replace the email optional box with a website or blog adress instead. I m pretty sure many people here have blog and I could check what they say, even though I would not write to them directly.

    Not that I want to move away from your blog, just to see for instance, hey whose that steve waldman or HZ, or anybody.

  • Posted by touche

    “I have proposed a way out of the rabbit hole.”

    There are only two ways out: Total economic collapse, or hyper inflation, though the latter is no picnic. I think politicians of both stripes will eventually see the light.

  • Posted by bsetser

    DF — i’ll see if there are any tech problems (or spam vulnerabilities) to your suggestion — i think some folks do input their blog address in the email line without problems, but i may be hallucinating.

    INTP — You read me right. The US has a flow problem. But for a country with a big flow problem, also lots of balance sheet strengthes. Particularly since many relatively short-term claims on the US are held by foreign central banks who are to a degree stuck/ motivated by factors other than pure return. Biggest balance sheet strength is financing yourself in your own currency at 4.5% when you have lots of foreign assets — that is the real dark matter on the US balance sheet. No risk sharing — all risk transfer.

  • Posted by HZ

    I guess causality confusion is the easiest thing in economics. When we discuss just a few factors we implicitly hold other factors constant and therefore may lose important interactions. I do appreciate the opportunity to look at things from the other side, which is also why I enjoy reading this blog and the comments.
    DF, it is good that in your new post you decoupled foreign flight from domestic demand. Foreign flight in of itself is clearly inflationary and is self-limiting, as long as the US economy is capable of producing goods and services that can meet foreign demands, which seems to be a secure assumption for the forseeable future.
    But you and Steve are right, that domestic expectation could turn and lead to deflation. In case when this is the stronger force it could overwhelm the inflationary force from a lower exchange rate. So I was incorrect in saying deflation and foreign flight are imcompatible. In theory they could happen together.
    Back to the original point, domestic deflation should lead to lower short rates and long rates, whether there is foreign flight or not. But in reality I think deflation is the least likely scenario, even with housing slowdown. As Joseph and DOR would say, I could take a look out of my window (or just at my bills) and see all signs leading to inflation.

  • Posted by HZ

    Here is causality confusion:
    deflation could lead to foreign flight; foreign flight should not lead to deflation

  • Posted by Maxed out

    Brad, isn’t a “savings supply” shock inevitable? The home ATM is closing down, China and Japan will accumulate much less $ and savings. Without these recycled $ who will the Treasury sell to. Are the Caribbean hedge funds really financing 80% of the U.S. current account deficit? Maybe China and the oil sheiks are working thru Caribbean banks – seems like a good way to have some fun. Especially China.

  • Posted by realist


    your solution calls for oil producing countries to consume more. that’s already happening in the middle east, and norway has become the most expensive country in the world, so how can it’s people afford to consume more?

    wouldn’t your weak dollar idea cause massive inflation in the u.s.?

  • Posted by PaulO

    Thanks for all your great work, and that of your great commentators.

    Same question as realist. Is there a risk of hyperinflation?

    If the consumer slows under debt loads, a housing regression to the mean puts lots of folks underwater (especially ARM and interest-only folks), and China decides it needs energy more than 4% US notes that will eventually lose all kinds of real value for them. Add to that things like the possible move away from the dollar as a reserve currency and aren’t we looking at a dollar collapse and subsequent high inflation (with the usual complementary high interest rates?)

    But on the plus side, wouldn’t that finally force Americans to save and start reallocating resources more efficiently from a world point of view?

    I can’t for the life of me see a reason to hold dollars right now.

    Am I missing something?

  • Posted by PaulO

    To be simplistic about it, isn’t an overvalued dollar sort of what got us into this mess (had interest rates risen in a non pegged dollar environment, the housing boom would have been less robust but more healthy, there’d be fewer SUVs, less HELOC and MEW putting people at debt risk, more savings, etc…)

    Isn’t a dollar revaluation down exactly what the doctor ordered to help fix things? Americans would then pay closer to the world price for oil and commodities, hence better decisions, US businesses could compete on a more even playing field in this labor arbitraged globalized world, savings would readjust, etc.

    Our financiers (China, Japan, Oil states) have got to know they’re not going to get paid back in real dollars worth what they hope. Given our economic policies now, they may get paid back in silly “helicopter” money, if at all.

    But I’d argue the rest of the world should America to be healthy and vibrant, and not just a hollowed-out shell. Apart from the criminals running things now, America has done a lot for the world to try to maintain stability.

    If we really are going into a peak oil kind of scenario, the world needs America to try to keep world wars from breaking out and to try to work things out diplomatically. Not to mention using our ingenuity and great education to come up with innovations to help advance everyone’s cause.

    With the Bush crew of Satans in there now it’s hard to imagine it, but a fully-functioning (if properly humbled) America is good for the world on balance.

  • Posted by DF

    Hz and all, the all point is precisely that domestic and world expectations are turning. The foreign flight will come from such turning expectations. This is why indeed in this case foreign flight will be coming with deflation.

    I wonder about China, I bet they will have a foreign flight too (in investment) and a deflation too.

    But how can there be simultaneously foreign flights in all countries ? A foreign flight of saving on the one side of investment on the other.

    How do you label the fact that the foreign situation looking out of control, simultaneously all people will want to repatriate their funds, at high transaction costs ?

    A globalisation at an excessive pace is the same thing as an asset bubble, it causes errors in allocations, underinvestment in the US industry, over investment in chinese industry.
    If you realise your investments based on the expectation that the globalisation process will continue forever at an increasing pace, even though local demand for your products is insufficient, then you are doing the same mistake as those who invest in a stock market hoping prices will go on forever.

    Globalisation has boosted investment globally and profits over wage, hence spending is only reliant on increased lending and excess capacity will appear at the minute the debt/GDP ratio stops growing.

  • Posted by bsetser

    Maxed out: Well, I thought some form of shock was highly probable, and wrote as much (my paper with roubini on the risk of a hard landing). So far, though, capital flows — whether from the Carib, London, China or elsewhere — have increased.

    Realist. in say 2001, the oil exporters consumption took up say a revenue stream equal to maybe $18 a barrel oil (am making that up), while oil was in the low 20s. Consumption certainly has gone up — I am working on some calculations now, but say it is now equal to the revenue stream of $30 a barrel oil (that is what is in the Saudi Budget, and the budget is the way oil $ get spread around). But oil is what, $65 plus a barrel — that’s a huge change. Consumption is up, savings up even more. Hence lots of $ cascading around …

    Paul O. Risk of inflation, sure. Risk of hyper-inflation. Not really. No major central bank will allow that now. Risk of inflation comes from higher import prices for manufactured goods ($ falls, import prices rise) at a time when oil prices remain relatively high and the like. But if the inflationary impact of a falling dollar is too big, the fed will jack up rates. And on balance, I am not sure that a “savings shock/ foreign flight” is deflationary, and that goes to the balance sheet effect that I should have mentioned earlier but didn’t. America is quite vulnerable to a fall in household wealth from a shift in the equilibrium nominal and real interest rate. Our balance sheet vulnerabilities are on the household side. And that would tend to slow consumption growth, and thus slow inflation — given that the $’s fall would act as a stimulus to 10-15% of the economy, push up prices for 15% of the economy (imports — actually less, since commodities are a seperate issue) while a slowdown in household spending b/c of weakness in the housing market/ higher rates impacts 70% of the economy, but “my gut” is that on balance, the inflationary pressures from even a signficant dollar fall will prove modest.

  • Posted by PaulO

    Fascinating stuff. Brad, thanks.

  • Posted by Dave Chiang

    Neo-liberalism Economics promoted by Robert Rubin, Thomas Friedman, and Larry Summers is responsible for the destruction of the American middle class and Industrial base. Under the Clinton Administration, Robert Rubin’s strong dollar policies overvalued U.S. exports resulting in the demise of the U.S. production base, but providing considerable economic benefits to an elite group of Wall Street bankers that profited from the outsourcing of jobs and technology. Special interests and the well-connected have grown stronger, while the U.S. national security, economy, health care and government have grown weaker.

    “Thomas Friedman, as an apologist for monopoly capitalism, in his book, makes status-quo enhancing recommendations that are deceptively ignorant of the state of the world’s poor – including the poor within the developed world. There is no leveling or flattening going on in America or the world. The new class structure in the US, with a gini coefficient of wealth inequality (calculated by economist Edward Wolff of New York University) of 0.84 (0 signifies perfect equality, 1 perfect inequality), reveals almost near total inequality, and intergenerational permanence (given historical analysis of the gini income inequality coefficient over the past generation- if anything, inequality is getting worse; the ‘intergenerational permanence’ is also explored in depth by sociologists Perucci and Wysong in their book , The New Class Society). Rather than a “flat” structure, the class structure within the US itself has become as rigid and resistant to change as the Hindu caste system”. – by M. Asadi

    Capitalism’s Suicide Bombers: Thomas Friedman & the “Flat Earth” Theory

  • Posted by psh

    er, no, Chicken Little’s gonna short the dollar and dollar bonds, go long Asian real estate developers while staying more or less beta-neutral by shorting them in the US, and buy calls on the VIX. Chicken Little’s gonna have a great meltdown.

  • Posted by ripley

    Brad said, ‘but “my gut” is that on balance, the inflationary pressures from even a signficant dollar fall will prove modest.’

    Do you mean CPI-style inflation or what a layman [me] would think of as a loss of purchasing power? I’m thinking of OER, hedonics, and the inflation in asset prices due to Bretton Woods II.

    Brad notes that commodities are a separate issue, but is that really true for oil? We import so much of it and we’re so dependent on it. I’m thinking of actual barrels of oil used, and not “oil as a percentage of GDP.”

  • Posted by bsetser

    Ripley — I meant to say “my gut” — i used my editor’s powers to change it in your comment as well as my original comment, hope that’s ok. I meant standard CPI. In the foreign flight scenario, interest rates increase and asset prices deflate. So a lot of the issues that we face now are less relevant. And given that the CPI will soon “price in” $65 a barrel oil, my argument’s doesn’t really hinge on the core CPI v CPI distinction.

    PSH — Why wouldn’t Chicken Little go long Asian real estate developers rather than long Asian central banks/ government backed financial institutions? The only problem Chicken little faces is China’s capital controls … which makes it hard to get 2.25 on RMB deposits … In any case, going back to my original post, there is some chance of consumer burnout/ no foreign flight — a scenario which would make shorting Treasuries costly.

  • Posted by DF

    There s also a case with consumer burnout so big that foreign flight does not matter for inflation.

    GDP growth is 4%, debt based money M3-M0 is still still growing some 8% a year. Just how long can this go on ?
    As soon as the gap is reduced, then deflation.

    This is why current debt level, barring direct emission of cash by the central banks (politically costly) ensures that deflation will happen sooner or later on a massive scale, imbalances notwithstanding, oil not withstanding, etc. notwithstanding.

    If the consumer is maxed out, just who will create money ?
    If the borrowers in general are maxed out, don’t believe they can borrow more without being 100% sure that bankrupcy is ahead … Who is going to create money endogeneously ?

    It is true that the US federal government has a huge margin to go further into debt, but the US and european consumers do not, some european states do not, many asian companies do not.

    Besides there are very clear signs that the public debt is understated, globally, due to differences between public and private accounting methods…

    The question is who gives in first, the US-european consumer or the asian producer, both carry debts based on foolish expectations (higher future wages, higher future exports)

  • Posted by psh

    That post was a ripoff of the most ghoulish recommendations in the Barrons investor panel this week. The real estate in question seemed to be all SE Asia. Why not China? They didn’t exactly say. Transparency, maybe, or maybe the relatively ripe state of China’s economic cycle, if you can call it that. Shorting treasuries, that idea came from their token gnome of Zurich, if I remember right. Bill Gross was sitting right there and he didn’t jump in with that globalization/corporatehoarding/pensiondemand argument for low rates (the one from the link up there), he just said the Fed doesn’t care about the dollar. Lots of consensus on the dollar sucking eggs.

  • Posted by DF

    aside from the hard landing scenario, UK has now entered the soft landing one, annual growth 1,8%, debt higher than ever, rising unemployment and bankrupcies…

    The UK housing market topped about 1,5 years ago, it has been since mostly flat.

    So the US according to this example would still have 1,5 years to go.

    A all lot of time to spend and have fun.

  • Posted by Gcs

    brad writes

    ” i see greater potential to increase consumption in the emerging world, and for the emerging world to drive global demand growth, and I see less potential for structural reforms in europe to play a meaningful role in global rebalancing.”

    bravo i couldn’t agree more

    better world creditors
    risk “the emerging ”
    over spending
    (if it ever need come to that )
    then as now
    letting uncle hog
    all “the free lunch “goodies

    bancor draft I
    in UN hands surely might have led
    by now to such an outcome

  • Posted by Gcs

    brad writes :
    “many relatively short-term claims on the US are held by foreign central banks”


    ” who are to a degree …..
    stuck/ motivated by
    factors other than pure return”

    another gemline brad
    and don’t that wreck all
    the “mechanical” models
    just so fine
    cause the cb’s are free adents
    not constrained to max anything
    the existing models can maximize

  • Posted by cranagh

    “Could you please learn to type without pressing the Enter Key (new line) for every couple of words ? ”

    Gcs -stay
    just the way
    all the world’s
    a stage
    and all the men and women
    merely players.
    they have their exits
    and their
    keys . . .

  • Posted by pgl

    Brad – have you seen the CalculatedRisk post linking to a paper by Charles Engel & John Rogers (J. of Monetary Economics)? Alas, my PDF reader is busted but the authors seem to be saying that our current level of debt (to the rest of the world) is optimal. Huh?

  • Posted by bsetser

    PGL — I just looked at it. I cannot take a paper that ignores emerging economies and focuses on the US share of advanced country GDP seriously. particularly if the same model that suggests the US should be running a large CAD also suggests fast growing emerging markets, whose share of world GDP is increasing, also should be running deficits. That would be all the more true if you assumed — as is reasonable, that market rates and PPP exchange rates will converge over time in emerging asia. If if cannot explain surpluses rather than deficits in the emerging world, it cannot get very far. I prefer Bernanke — at least his thesis is consistent with observed facts. Same can be said for Dooley et al.

    Basically, the model seems to explain why Japan and Europe might be financing the US, but the big shift since 97 is not a surge in Japanese/ European financing of the US, but a surge in emerging market financing of the US —

    I also have trouble getting past an introduction that list capital market imperfections in emerging markets as an explanation for the US current account deficit (presumably b/c those imperfections drive private savings away from emerging markets) and ignores reserve accumulation in emerging markets. seems to me that the surge in reserve accumulation from $100b a year to $500 b a year in the emerging world might have more to do with the current global flow of capital than capital market imperfections. Last I checked, private capital was flooding emerging markets at about the same pace as 97. See Philip Coggan.

    Maybe I am bitter ‘cuase i didn’t see a roubini/ setser reference. but in general terms, i tend to be more impressed with models that suggest the authors are familiar with the data tables at the end of the IMF’s WEO than more speculative exercises that assume away the emerging world.

    rant over!

  • Posted by Joe Rotger


    On your rabbit hole evacuation measures,

    – I agree that the US govt should reduce its overspending. I would recommend this to anyone that is or will not be able to match his expenses…

    – On the other hand, I can’t agree with your recommendation to emerging high surplus economies to go out in a spending spree… b/c they’ve worked hard and saved too much? They’re already doing a lot for the irresponsible spenders; they’re lending them at extremely convenient low rates… And, they in turn are putting away — or SAVING –their hard earned USDs for leaner years — in US Treasury bonds and such. In sum, I don’t feel it’s correct to preach different roads to heaven to different people; it’s either that it’s good to save or we all go out on a spending spree?

    – In regards, to asking China et al to raise their prices, or to raise their currencies; heck, I can’t see the US moral right to ask this from anyone? These people are only willing to do the same or more for less pay; is that a crime? And BTW, US consumers also have been benefiting from low prices; they continue to enjoy a better standard of living.

    Of course, what I’m saying solves nothing; but, sets the moral tone, if anything.

    I guess I’m trying to present how easy it would be for China et al to counter your arguments…

    On the more general judgment day discussion, I think somebody said it a few days ago, it’s not going to happen; the creditor is already too far into the debtor’s quagmire of debt. The bank will have to help out the debtor out of his situation — if it’s not being already coordinated as we speak.

    Maybe some refinancing to the reappearing US 30 year bond to lower cash flows…
    + a little loosening in the Yuan/USD rate to help the trade deficit…

    Finally, it seems that everybody thinks the USD is going to drop. I don’t – or just a little.

    In relation to what?

    As I see it, most countries try to conserve (even increase…) employment. Raising local currencies is a sure way to price themselves out of the market, which leads to deflation, and counter to governments which feel accountable to the unemployed voters…

    I’m sure this is the reason why USDs from oil producers and other surplus economies, inevitably find their way into the US; no one wants to hold the USD cash hot potato, they all would rather help the USD Treasury sterilization to preserve its pricing.
    In conclusion, no shocks, slow grinding “a la Gross” for the next 10 years while the US accommodates to what the PBoC et al bankers say. Low rates, low prices…

  • Posted by Joe Rotger

    One final thing,

    Borrowing is a way to spend today, future income.

    There’s a lot of room here, mortgaging future generations to continue present spending.

    I also feel long term bond sterilization is an excellent way to remove USDs from the present…which is why long term bond buying is crowded and their rates low.

    Borrowing by mortgaging the future can go on for a very long time…

  • Posted by DF

    the yeld curve :

    THis article offers another self deserving explication : rising retirements and changing pension accounting rules explain rising demand for long term bonds. Hence the fall in long term rates. And there fore the inverted yeld curve does not mean anything

    Joe rotger you wrote
    n sum, I don’t feel it’s correct to preach different roads to heaven to different people; it’s either that it’s good to save or we all go out on a spending spree?

    I think you need to realise that when you say to one guy save more and to another save more you are not preaching different roads to heaven. You are teaching exactly the very same road, the middle road.
    It’s dangerous to oversave overinvest, this create overproduction crisis. It’s dangerous to undersave under invest, this creates stagnation.
    And it’s dangerous to overlend overborrow, this ensure future crisis.

    if there’s one road to heaven and some are on the left of it, you ask them to move to the right … and vice versa.

  • Posted by Joe Rotger


    I understand what you’re trying to convey.

    But, I don’t see Warren Buffet hurting too much b/c he’s gone too far to one side of the road, nor China for that matter; and yes I do see the hurting on the guy that’s taken too much debt and is spending more than his income.

    I tend to think we should be leaning a bit more on this strayed poor fellow than the Buffet Treasury saving kind…

    Middle of the road? Why?
    Could it be the tainted glass perspective of the guy in trouble?

    Is it bad to have a wad of USDs in your purse?
    I’m looking forward to someday being able to answer this question with first hand experience.

  • Posted by Joe Rotger

    I just read the Bloomberg note, interesting article.

    So, additionaly there are demographic reasons for a low long term rate too. BTW, China has an enormous aging population…

    BTW, I woudn’t discount totally the significance of the inverted yield curve.

    It is basically saying that the Fed’s effort to hamper liquidity through short term rate increases is being unravelled by a loose end at the long term rates; where the PBoC and other foreign CBs are using a different method to remove liquidity, long term lending at very low rates to promote present consumption.

    It further says that the Fed cannot sustain these rates in the face of an increasing trade deficit, brought about by an increase in the USD due to higher Fed rates.

  • Posted by DF

    Joe, basically saving is good depending from how much your neighbor saves.
    If there is a production of 100, Investment of 20, Consumption 80, wages are 60,And people who earn returns on their assets get 40. wage earners do not save, spend 60, asset holder spend 20 and save 20.

    Suppose, suddenly, all wage earners start to save 10% of their wages, bam, consumption falls to 74. That may happen because say they fear for retirement, they have debts, whatever.

    What happens to production ?
    Suddenly there’s too much production, then prices fall, lay offs etc. The example looks like the USA now.

    You may say : OK but it started because people saved not enough.

    True in that case, but the opposite can happen,

    If there is a production of 100, 50 final goods, 50 investment goods, Investment of 50, Consumption 50 wages 60 And people who earn returns on their assets get 40, wage earners save 20 and spend 40, asset holders spend 10 and save 30.

    The next year, production has doubled because of investment, but people encouraged by the success, save even more : there’s not enough demand for the products, the country needs to export, then, there’s not enough demand,… And suddenly the country realises it has tons of new plants coming on the market, and there are no consumer for them…

    Saving more than your neighbour is always good, however when dealing with a country and even better with a world economy, it’s better to have a balanced saving rate ensuring stable growth.

    It’s exactly the same as university and shooling, if all people go to university and get a bachelor then you have to go their and get a master. That’s how

  • Posted by Joe Rotger


    Just so we have it straight, I’m not giving one hiota of my future wad of USds, say what you will…

  • Posted by dave iverson


    Have your concerns about deflation and credit bubble dynamics been adequately discussed here? I wandered over just now to Nouriel Roubini’s blog just now and found this in a 1/27 post titled “Global Imbalances, the US Dollar and Globalization Challenges at Davos…” which in my mind doesn’t discount what you’ve been arguing. At least I don’t think that Stephen Roach would deny the possiblity for a deflationary outcome post bubble burst, and I suspect that Nouriel Roubini would not either.

    “… At the initial panel on the global economy only long-term bear Steve Roach from Morgan Stanley repeated the bearish outlook on dollar, the US economy and the risks of a disorderly adjustment triggered by the bursting of the US housing bubble. I happen to share the concerns of Roach even if, now, rather than a hard landing I predict for 2006 a significant US and global slowdown and a significant fall of the dollar but not a free fall. …

    “[Larry] Summers argued that the two forces driving markets are “hope and fear”. His concern is that, on cyclical issues there is too much hope – i.e. complacency about the global imbalances – and not enough fear that asset bubbles and imbalances may lead to a disorderly adjustment. On long term issues such as the emergence of China and India he argued that there was too much fear (that China and India will take over the world with severe effects on unskilled labor in advanced economies) and not enough hope that the emergence of China and India and their intregration in the global economy will have long run beneficial effects. Summers went as far a suggesting that the emergence of China and India (and more broadly of the BRICs and emerging market economies) may be the third most important development in the last millenium, next to the Reneissance and to the Industrial Revolution. This is quite a bold statment that may have some truth.

    “But Tyson warned of the potentially negative implications of the emergence of China and India for unskilled labor in the advanced economies. With two billion plus workers in China and India joining the global economy this increase in the global supply of labor should lead, based on simple trade theory, to a long run reduction in the relative equilibrium real wage for unskilled workers in advanced economies. This reduction in real wages and increase in income inequality such as the once observed in the US in the last few years is a source of fraying of the ‘social contract’ that, in exchange for accepting globalization and freer trade guaranteed to manufacturing workers good wages and good benefits; for auto workers and other blue collar workers such manufacturing jobs were the ticket to entry in the middle class but both employment, real wages and benefits are being significanttly erored by globalization.
    Summers echoed the concerns of Tyson when he said that we have a serious problem when globalization is associated with ‘local disintegration’ in places such as Flint (home of former now closed down US auto plants), with the emergence of failed states and with with struggling middle classes. To be successful globalization needs to lead to local integration not local disintegration.”

    PS.. Brad.. I don’t think I’ve participated in any of your discussions since you change formats. For whatever reason I only see a partial “preview” rendering of my comment. Perchance that is intended to keep comments short. Or perhaps not.