The q4 current account deficit
Count me among those who were surprised by the size of the fall in the q4 current account deficit. I was expecting a fall, but not as big a fall as the BEA reported this morning.
The q4 deficit came in at $195.8b, down from $229.4b in q3. Add in a $213.8b deficit in q1 and $217.7b deficit in q2, and the annual deficit came in at $856.7b. That is about $200b more than the 2004 deficit.
A significant fall in the q4 deficit was expected. The big fall in oil prices in q4 — together with decent export growth and relatively subdued non-oil import growth — brought down the trade balance. But the size of the fall was bigger than I expected. I thought the income balance would continue to deteriorate. Instead, it improved — a q3 deficit of $5.3b turned into a q4 surplus of $3.0b. I was expecting something more like a deficit of $8b — or was until the flow of funds data came out (it also showed an improvement in the income balance in q4, see table F107)
The q4 income balance likely will be revised downward over time. That has been the pattern this year (note the rise in the estimated current account deficit for q1 and q2). And some of the details of the q4 data seem a bit strange. The earnings of foreign direct investors in the US fell by over $5b in q4. Sure, the US slowed, but I thought Toyota still was doing rather well. The microdata indicates the fall comes entirely from a huge fall in reinvested earnings, which more than offset a rise in distributed earnings.
Seven other things jumped out at me.
1. The US borrows to consume, not to invest. That at least is the story of the flow data. US equity investment abroad exceeded foreign equity investment in the US (counting portfolio equity as well as FDI) by about $80b. The current account deficit by contrast was around $860b. Think of it this way: the ratio between borrowing to invest ($80b) and borrowing to consume ($860b) was about 1: 10. The true global financial intermediaries of today's world are found in Europe, as London and a host of eurozone financial capitals take in large sums from Asian central banks and oil exporters looking for alternatives to the dollar and use those inflows predominantly to finance their external investment. So long as Euroepeans didn't use central bank inflows to buy too many CDOs backed by subprime US mortgages, that presumably is a good business.
2. The rise in the US oil import bill accounted for most of the deterioration in the US current account deficit in 2006. As Menzie Chinn has highlighted, the non-oil trade deficit has stabilized on the back of strong export growth and slowing non-oil import growth. The transfers deficit fell in 2006, as US government grants fell by about $10b (from $30b to $20b) — think a fall off in budgeted economic aid to Iraq. And the deterioration in the income balance — $20b — was smaller than might be expected. The US afterall needed to take on $850b of debt at say 5% to cover its current account deficit, which implies a roughly $40b increase in its interest bill …
3. Optimists will no doubt argue that the q4 data shows that the US deficit has peaked. I am not so sure. If the US avoids a recession, I doubt the US non-oil trade balance will improve significantly. Oil now looks to be in the $60 range — so it is hard to bank on further improvements. And I don't expect the q4 improvement in the income balance to be sustained — so I still expect a deterioration in the income balance to push the 07 deficit toward $900b, absent a recession or a big fall in the price of oil.
4. Believers in dark matter will take comfort in the fact that the US earned almost $300b on its direct investment abroad, while foreigners earned only $150b on their direct investment in the US — and increase of $15b over 2005. (The actual numbers are $295.9 and $145.6b). Thanks to the strong performance of foreign equity markets, the market value of US FDI abroad exceeds the market value of foreign FDI in the US — but not by a ratio of 2 to 1. The reported rate of return on US FDI is still higher than the (very low) reported return on FDI in the US. Skeptics will note that $130b of the $150b difference comes from "reinvested" earnings; the gap is a lot smaller when you just look at actual distributed profits. US firms reinvested $213b abroad, foreign firms reinvested only $80b in the US. My take: the very low reported return on FDI in the US suggests that the US data is undercounting the real profits of foreign firms operating in the US.
5. Interest payments on US debt rose by $137b in 2006. But the interest receipts from US lending rose by $102b, almost as much. Both totals include dividend payments on portfolio equity, but those are small. Rising debt and rising rates increased US interest payments, as one would expect. But the rise in US interest receipts was more impressive — and seems to reflect the very short-term structure of US external lending. As short-term rates rose, so did US receipts. My forecast for 2007 assumes the rise in debt payments will continue, but, not that the Fed is on hold, the rise in US interest receipts will stall. The result: a big deterioration in the income balance.
6. Recorded net debt inflows of around $800b fell short of the $940b the US needed to finance its $860b current account deficit and its $80b equity investment abroad. In other words, the errors term was large …
7. Recorded official inflows rebounded from their 2005 low, reaching $300b. Think $120b in treasuries, $125b in agencies, $20b in bank deposits (onshore) and $30b in other (mostly corporate bonds, but some stock). However, $300b in recorded inflows still seem small relative to the roughly $900b increase in foreign official assets ($750b of reserves, $150b roughly in oil investment funds, including Norway). I think official actors put more than a third of their assets into US dollars. Some of the gap is explained by the growth of central banks' offshore dollar deposits (though that growth stalled in q3, according to the BIS data). But some of the gap is also explained by the use of custodians for central bank purchases, and the fact that some central banks and oil funds use private managers for a share of their portfolios.
Update — the BIS data (table 5c) suggests that offshore dollar deposits are on track to rise by between $125-135b this year (they are up $100b ytd), offshore euro deposits are on track to rise by $75b, and offshore pound deposits to fall (ball park) by $25 — after a huge surge in pound deposits in 05, central banks have been paring back, though it isn't clear whether they are shifting into other pound assets or not. I don't think the COFER data suggests a comparable fall off in pound reserve growth, just a slower increase than in 05 — but the COFER data has gaps. Sum up the $300b in US inflows and $125b in offshore dollar deposits — the $425b total (which may have some double counting) is still on the small side relative to the $900b growth in official assets; hence my belief that there are some official flows masquerading as private flows in the US data.
The US trade deficit of $857 billion in 2006 boggles the imagination. With the deficit representing a record 6.5 percent of the total GDP, the US has totally abused the reserve currency status of the dollar. Any concerted effort by the Federal Reserve to hyperinflate covering subprime mortgage losses by Wall Street would completely destroy the U.S. as an economic power. The United States needs a serious reality check. I have a feeling it’s coming.
Chiang-
I’m not happy with the dollar policies of the US either, but I’ve heard other people say this and I think it makes sense… doesn’t there have to a viable (liquid and transparent) alternative for “investors”/CB’s to flee the dollar? Our markets dwarf the next biggest (Japan)… where are people going to go and if they “give” their money to another nation will it act as their bodyguard?
Gamma, you just laid out the case for higher gold prices.
some folks seem to worry that they may get mugged by their bodyguard — and i am not sure if say the saudis see the uS actions in Iraq (with hindsight) as a net positive for their interests.
the problem isn’t that there aren’t markets that are big enough — the eurozone is absorbing $200-300b in net CB/ oil fund inflows. the problem is that you cannot peg to the dollar and put all your assets in euros without driving the dollar down v the euro. the yen could also absorb more flows than it gets — the Japanese have a decent fiscald deficit and a big stock of marketable (albeit low yielding) debt.
As Ben Bernanke explained, “the Federal Reserve has a printing press, and to prevent an economic downturn, we can drop money from a helicopter”. Except to combat the massive trillion dollar losses in the mortgage market, Bernanke will need to deploy the fleet of US Airforce C-17 Cargo aircraft for the money drop on the US Economy.
Just tack an extra zero at the end of all our prices. This nothing a little hyperinflation can’t fix. All these people making 30K will be making 300K. Then they shouldn’t have any trouble paying their 700K mortgages, as long as they don’t drink too many $500 cups of coffee.
Thanks Alan Greenspan and Ben Bernanke for the credit bubble mess that you guys have created.
Setser-
How big is the Japanese debt market? I know their equity market is something like 4 trillion compared to our 22 trillion (some ratio like that). China is at like 2 trillion on the equity markets. If the debt market in Japan is on a ratio anywhere near the equity market ratio… then it doesn’t seem anywhere near liquid enough to handle a mass exodus from the dollar…? Also, who wants to invest in Japanese debt when my understanding is that they just let things “rot” rather than having a true reorganization, default, etc. Don’t they still have tons of NPL’s on the books there?
As always your insight is appreciated. Great blog… thanks for all your hard work.
MichaelM- I’ve been a believer in the coming asset deflation with “needs” (aka commodity) inflation. That may drive gold (my old opinion), but as many people have pointed out… you can’t eat gold or drive your car with gold. I think gold is more likey to underpeform other commodities. I’m not saying it can’t go to 2000 (anything is possible), but if it does… other commodities will be up by bigger percentages IMO.
Chiang -
“credit mess YOU GUYS created”. who are you referring to?
DC:
According to all the figures I have seen, the mortgage subprime scandal will hurt, but not on the scale you described. Assuming 20% of the $600B subprime goes bad(Center for Responsible Lending figure) and assuming another 1-2% of mortgages resetting this year goes bad ($3T resetting this year), the overall exposure to the econcomy is $200B to $250B tops. This is comparable to the expected loss PBoC will take with a sharp revaluation of the Yuan. The unknown is whether the fear of crisis will drive behavior that will cause a wider crisis. Also unknown is whether governmental stupidity will cause something else bad to happen. Overall though, I believe the US, like China, will muddle through this and will only do the necessary to patch up the system and prevent it from breaking big time.
In defense of their regulation of the US mortgage finance market, Federal Reserve officials defend their approach, saying that over- zealous regulation might “cut off credit” to people who need it most.
Now we have potential subprime and Alt-A mortgage default losses in the trillions of dollars with taxpayers holding the bag for hundreds of billions in US Treasury guaranteed loans at Fannie Mae. The game is so rigged against honesty, it boggles the mind. We have had a mindless Housing bubble that was precipitated by a complete abdication of responsibility on the part of Fed monetary policy.
From Prudent Bear, Fannie Mae and Freddie Mac are effectively bankrupt from non-performing mortgages:
http://www.prudentbear.com/articles/show/1326
” Home mortgage debt was $10.7 trillion in 2006, of which Fannie and Freddie had guaranteed $3.4 trillion and owned directly an additional $400 billion. Sub-prime mortgages represented 13% of the outstandings and mortgages with negative or no amortization represented another 27% of the $6 trillion of mortgages originated in 2005-06. Add the two together, and you have roughly $1.4 trillion of mortgages sub-prime and another $1.6 trillion of mortgages endangered if interest rates were to rise sharply.
Not all these mortgages will default, maybe only 1/3, and of the defaulters the losses will be limited, maybe 25% of principal. That gives losses on this mortgage pool of 8.3% of loans outstanding, or $140 billion. Just under $1 trillion in losses between the two categories, not counting whatever defaults may occur on prime mortgages. However there’s a snag here, and that’s Fannie and Freddie. With $3.8 trillion of the $10.7 trillion of home mortgages, they should suffer $350 billion of losses.
Finally, there’s the disruption effect. Fannie and Freddie may have only $79 billion in capital, but they have guaranteed $3.8 trillion in mortgage loans, nearly 30% of U.S. Gross Domestic Product. Thus the housing malaise, in house prices, national wealth, loan losses and market disruption, is likely to be gigantic, and will inevitably spread into the rest of the economy. “
I am decidedly not an expert on mortgages/ housing — and generally leave commentary on that to the RGE resident bear (i.e. the boss). But did $6 trillion of the $10.7 trillion in outstanding mortgages really orginate in 05/06 — that seems on the high side to me (again, w/o following the data — mortgages are longish term things, and well, i wasn’t aware that there had been that much refinancing). and the assumptions required to get $350b in losses on the agencies $3.7 trillion in mortgages seem off to me — i would assume that the agencies generally hold the top end of the mortgage pool (the documented bit with a sane loan to value ratio and fixed rates), and since the market share of the agencies has been falling, a comparatively smaller share of what i take is the really toxic stuff (i.e. lending in 06)
gamma — the fall 06 (q3) BIS quarterly if i am not mistaken has charts showing the comparative size of the US/ euro/ pound and yen debt markets broken down by credit quality and the kind of assets that central banks look for in reserves. there is a lot of GOJ yen bonds (JGBs) out there though — they aren’t triple A if memory holds, but they are still decent reserve assets. the problem isn’t one of availability; it is that the JGBs have very low yields and their value has been falling v. pretty much everything ($, euros, etc)
DC:
The numbers worked out from Prudent Bear actually come to $250B in losses, in line with what I had estimated. The last paragraph is problematic for the reasons Brad alluded to. I also have a problem with the statement of gigantic loss. What qualifies as gigantic? $500B or $1T?
Also, if the problem got beyond $250B, doesn’t Chimerica East (to paraphrase Niall Freguson) have an added incentive to jump in and prop up the system? (After all, they hold quite few of Fannie Mae and Freddie Mac debt.) Is it a coincidence then that PBoC (or Fed East) just set up a $400B fund for “investments with more risk”? Does anyone know if PBoC prohibits the use of this fund as bail out fund of last resort to keep Chimerica West stable?
MichaelM, it’s an equally effective case for higher prices of moondust as well. The problem with gold is that there simply isn’t enough of it to make it viable as a reserve asset without doing substantially more damage than good.
DaveChiang, base money growth and even M2 in the US has been running at a growth rate in the mid-to-low single digits for the apst several years. If you wish to assign blame for the superabundant liquidity available to financial markets in the US and elsewhere, the FX reserve managers would be a pretty good place to start.
Moreover, the US current account deficit is large, and part of that is clearly down to the high marginal propensity of US households to consume. However, the policy actions of China and other FX reserve managers who maintain artificially weak exchange rates are also culpable. Not simply because of a price effect, which is probably small in the grand scheme of things, but more because of the distortions that several hundred billion recycled dollars per annum into the financial system creates. There is just no defensible reason why China needs to accrue reserves in the way they are doing.
I also suspect that your doomsday scenario for the US mortgage market is overstated. Current subprime default rates are 13 and a bit percent. Prime default rates are 2.57%. It is a stretch of Stretch Armstrong proportions to get from there to the agencies losing the kind of sums you are proposing. And if the mortgage industry utterly implodes? Well, on the bright side, PBOC will probably have a few less reserves, given the amount of mortgage product (not all of it Agency)on their books.
Sorry, that last post was from me; I’d hate for anyone to think I was hiding behind a cloak of anonymity
From Mike Shedlock at his Global Economics Blog:
http://globaleconomicanalysis.blogspot.com/2007/03/malinvestments-predatory-lending-and.html
” “We’ve created unproductive economic assets with the Housing bubble,” says Joe Carson, director of global economic research at AllianceBernstein. “A house doesn’t produce income.” Mortgage debt rose by $4.7 trillion from the end of 2000 through the third quarter of 2006, according to the Fed’s Flow of Funds report. “We created as much debt in housing in the last six years as we did in the prior 50,” Carson says.
Bingo! Austrian economists would call this malinvestment. For all this artificial boom, we did not create any productive capacity, we did not even improve infrastructure. All we did was pile on debt. That debt will not be inflated away, wages will simply not rise fast enough, and jobs will become harder to find in the upcoming recession. That debt will be deflated away via bankruptcies. The process has started and it has a long, long way to go before it’s over.
Instead of spending money on productive assets we are actually selling assets to foreigners to finance our reckless spending habits. We have also wasted what will eventually amount to trillions of dollars to blowing up Iraq, and since no one else is willing to say this, I will: Every life lost in Iraq was wasted as well, every single one of them.
Compare and contrast how we have been wasting dollars to what China and India are doing with their dollars. Yes, China has built tons of overcapacity, but unlike us they at least have capacity, and unlike us China and India have massively improved infrastructure while we have allowed ours to go to waste. Proof of that statement is easy. Schwarzenegger needs $500 billion to rebuild California infrastructure.
The market is in the process of repricing those malinvestments right now. That is why subprime lenders are blowing up, home prices are falling, defaults and foreclosures are rising, and credit lending is imploding. In attempting to prevent deflation the Fed has essentially guaranteed it. Congress played right along giving the banks and credit card companies exactly what they wanted: A bankruptcy reform act written to make people debt slaves forever. This fostered risky credit card lending in the belief that those loans will be paid back. They won’t.
Instead of taking a hit in 2002, Greenspan and Bernanke made matters worse by creating the mother of all housing bubbles. We are following in the footsteps of Japan except that our consumer debt loads will make it worse. The Fed has learned nothing every step of the way. “
for what it is worth, our resident housing guru puts combined o5-06 new issuance at around $2 trillion, which makes sense to me given the stock of roughly $11 trillion — and i second macroman’s comments.
Brad,
While there was a net combined $2 trillion new issuance of Home mortgages, during that period of 05-06, there was a substantial refinancing boom that accounts for the total $6 trillion mortgages originated. For instance, I refinanced in 2005 from 7.8% to a new mortgage of 5.8% on a 15 year loan. Previous subprime mortgage holders also simply refinanced before adjustable balloon interest rates reset to higher levels. But with Housing prices slumping and interest rates somewhat higher than 2005, subprime and Alt-A mortgage holders with negative equity are having the refinancing lending window slammed shut in their faces. For most, the likely outcome is default.
Regards,
subprime is ‘only’ ~10% of mortgage debt outstanding (from around 5% in 2001) and only a fraction of that — mostly 2005/2006 vintage loans — will ever likely go under and even then, as salmon might point out, the recovery rate probably isn’t too bad; the housing standard lives another day…
“The best and indeed only argument for gold is the view that we must, sooner or later, return to rampant inflation. That has been the rule for fiat money throughout most of human history. I think today seigniorage is not an important source of government revenue and financial markets punish politicians for inflation pretty quickly. So I am willing to wait for the “later” to come before making any switches away from fiat money. Keep in mind, people can already denominate their contracts in terms of gold, and hardly anyone wishes to do so.” http://www.marginalrevolution.com/marginalrevolution/2007/03/should_we_retur.html
“you can’t eat gold or drive your car with gold.”
you can’t eat pieces of paper or electronic digits, either. Money should be: a store of value and a medium of exchange. Precious metals serve this purpose better than paper money.
The lack of a truly free monetary market (Central banker meddling) has gotten us into this mess. What can be done to fix the problem? Nothing short of severe economic pain.
Relative to paper, gold is cheap. Just my opinion.
I too have trouble believing that the income balance of the US became positive again in Q4 2006. One of the indicators of data quality is the absence of a large fudge factor. However, the statistical discrepancy keeps growing over time. In 2006 alone, there was a whopping $141B in unaccounted-for capital flows. Really, what does it matter if the recorded US income balance is up $7B or down $7B for the year when your fudge factor is $141B? (A magnitude of 20x?)
I look forward to the BEA’s revisions–major, major revisions.
DC — googling around, I found an estimate for mortgage production in 06, counting refis, of $2.5 trillion. Not sure what the 05 number was, but if it matched the 06 number, the sum is $5 trillion — which isn’t far from the 6 trillion. So in broad terms, it looks like you are right. my intuition (no way 1/2 of all mortgages, including refis, are from 05/06) was off.
the 2.5 trillion estimate comes from the mortgage bankers association; they were estimating 2.3 trillion for 07 in january, but that looks optimistic.
Emmanuel — well, one way to get rid of the statistical discrepancy is to argue that the uS data is understaing the US income surplus, and thus overstating the deficit … I don’t buy it, but the errors term suggests looking for fx receipts or inflows, not additional payments!
Just curious about rumours I’ve been hearing about the Chinese central bank using third party companies to short the US dollar in derivative space. Anybody confirm? I guess they may be doing this to hedge against their dollar denominated loss exposure as the yuan rises. Still seems a bit nefarious, almost equivalent to the Fed shorting Fed Funds futures when it knows it is going to raise rates…
First I have heard of that rumor, but it sort of makes sense — presumably the inv co will have a slighter lower $ propensity than SAFE, and, well, the Chinese are worried about their $ exposure. I have heard that some other asian central banks (not the PBoC) have done swaps to reduce their effective dollar exposure, but when looking at how the stated reserves of a couple of the supposed hedgers responded to the dollar’s move in nov, I didn’t see much evidence of the hedge. The persistent rumor I have heard (and believe) is that the PBoC is active selling insurance (calls i think, and effecgtively covered calls, but someone who knows can correct me) against big moves in US rates (i.e. big moves in the price of US bonds) as a yield enhancer.
Macro Man is right that CBs can’t just diversify into gold the way they could (perhaps) into euros. There is no gradual way to go back “on gold” - the required price change is too drastic.
That said, it is interesting that CBs seem to have stopped selling the stuff and a few are even buying a little. But this is ordinary reserve management, not a policy feeler. CBs are not suicidal.
The only conceivable realistic scenario for a return to the gold standard is a feedback loop driven by retail investment demand. It doesn’t take a PhD in economics to figure out that in a world where short-term liquidity is growing by 15-20% and long-term bonds offer 5%, any cheaply storable commodity with an inelastic supply whose demand can stay anywhere near proportional to the amount of money available to buy it will beat official paper like a drum - or that the commodity to pick is the same one that everyone else will pick (ie, not moondust). If any significant quantity of savers, anywhere in the world, reaches this conclusion and cannot be dissuaded by short-term volatility, CBs don’t really have the tools to stop them. How do you think the stuff got to be money in the first place?
So if CBs manage a return to gold, they will do it not because they want to do it, but because they have to, and (being, after all, socially responsible) they want to make the process orderly rather than chaotic.
An orderly return to gold has to happen in one step - ideally it would be without any public warning at all - and it has to involve a very, very large amount of debt monetization, because it would end the practice of CBs generating liquidity to buy their own bonds. The alternative is 1930s style debt deflation - yuck. So the number you need to divide into the world gold stock is not M0, or even M1, but much larger.
Of course, there is an upside - Goldilocks for real, a permanent state of low interest rates, no business cycles, no FX risk, etc, etc. At least if you believe the Austrians.
I suspect Benn Steil, who is surely no monetary naif, has done some thinking about this.
Don’t even start me on the Marginal Revolution guys. Just because you call yourself a “libertarian” doesn’t mean you are, and it certainly doesn’t enable you to remain blissfully ignorant of the Austrian corpus. Let alone claim that CB monetary creation has minimal effect on the global economy! Give me an honest neo-Keynesian any day…
DC — I stand corrected on total mortgagte orgination. it was 3 trillion in 05, which puts the 05/06 total at close to 6 trillion (04-05 total looks to be 5.7 trillion). and total orgination in either 02 or 03 (I don’t have the data in front of me) as something like 1/2 the stock outstanding. so everyone more or less did refinance … except poor sods like me who rent.
MichaelM-
I agree that gold is cheap compared to paper. My point was simply that other commodities are likely (in my opinion) to outperform it.
From Bloomberg, Merrill Lynch is warning its clients that the US Economy is tipping into Recession. No small irony that Merrill was one of the main actors in the unfolding Subprime mortgage fiasco. And where were the Federal Reserve regulators, obviously they have been sleeping on the job with the US Banking system soon to require a massive taxpayer bailout. With risk piled sky high in trillions of dollars of financial derivatives, who know where this will lead. Warren Buffett calls financial derivatives, “a weapon of mass destruction”.
http://www.bloomberg.com/apps/news?pid=20601103&sid=aYtEcwn_eunw&refer=us
Merrill Lynch was also saying in late 2005 that Fed funds would be 3% at the end of 2006. You’ll pardon me if I don’t accept that forecast at face value. JP Morgan, on the other hand, suggests that the subprime problem should be ‘relatively well contained.’ So no matter what your view, you can find an ‘expert’ to back you up.
when crash happen, the money does not need any haven to flle to : it simply is erased.
Bankrupcies will take care of all that excess liquidity, expect deflation big time.
Brad, our favourite mega-deficit carry currency country just got downgarded, just like this time last year. Unlike last year, no one seems to care….
macroman — meaning that the 12 hedge funds and 3 trading desks that are long our favorite little high carry big current accout deficit country are still long? (numbers are made up, but isn’t there a fairly limited of players in that particular market, or am i underestimating how much activity a country with under a million people can generate in a globalized world … )
Moldbug,
Perhaps what is wrong is not the nature of the stock of assets that backs money, but the marginal asset - short term debt. Even under the gold standard, short term debt tended to be used as the marginal asset. In other words, fixing short term interest rates has become synonymous with monetary policy.
Since central banks are supposed to be stabilising the value of their money in terms of the consumer price basket, it might be better for them to set its exchange value in terms of a basket of suitable assets (gold, maybe, but foreign currency, copper, oil, grain etc too) with a closer relationship with the cpi, and operate frequently in the markets for all of those assets. Then, debt prices - ie interest rates - would be free to provide a natural stabilising mechanism.
Well, I made some inquiries with the shop that has consistently provided me with the best info on this little gem of the North Atlantic.
The sum of the feed back was that insitutional and bank positioning is much lighter than last year and more cognizant of the macro risks involved with Iceland. On the other hand, retail investment is substantially greater- retail investment, incidentally, that probably doesn’t have a screen on 12 hours a day and isn’t liable to get a tap on the shoulder from the boss asking when they are going to stop out.
Certainly one high-profile IFA has publicly favoured Inceland for some time, noting that “My my interest in Iceland as an investment destination stems from the belief that it will become evermore important in the world economic order.” I’m not sure why, but there you go…
http://randomroger.blogspot.com/2007/03/odd-hat-tip.html
the world has changed — it is now dominated by retail carry traders (on the destination side in the north atlantic, and on funding side in an island in the north pacific) and official institutions …
great quote by the way (Iceland and world economic order) … way off, of course, but it is a nice thermometer.
Well, Iceland is certainly centrally located! And positioned to profit from global warming…
RE,
Hayek, among I’m sure many others, once proposed commodity basket currency. This did not get a very good reception from the Austrian world.
Any good that is used as money (ie, that is stored for the purpose of later exchange) is going to have very different economic behavior from a good that isn’t. In an economy that uses dried yak tails as money, you will see a very unusual number of yak tails (and probably yaks), and an unusual premium applied to yak tails as opposed to, say, goat tails.
You can tell that gold still has some monetary role, for example, because if you analyze the stuff using the same models as those that work for industrial commodities, they tell you to sell, sell, SELL. If the world had a 50-year stockpile of zinc, tungsten, ruthenium, or whatever, and was still mining the stuff, one would be very surprised. And if some financial magician can come up with a way to fix the fiat currency system, gold can and will fall to two-digit prices.
Why - especially in an era where electronic tokens negate much of the advantage of compactness - is gold monetary and all the other transition metals not? Obviously it has nothing to do with chemistry. It got that way for historical reasons. It is simply one case of a path-dependent multiple equilibrium.
Monetary systems which depend on multiple heterogeneous commodities are notoriously unstable. Look at the history of the gold-silver standard. It was a permanent disaster. If you try to fix the ratio, any natural fluctuation in the supply or (non-monetary) demand can make one of the metals instantly a better money than the other. If you let it float and go with parallel currencies, same thing - one of the metals starts to win and keeps on winning, until its rival or rivals are completely demonetized.
Also, the word “backed” is very tricky and can mean a whole lot of things. In an ideal electronic commodity standard - such as the modern digital gold currencies, or the ETFs - a token or a share denotes strict equity. It is not a liability of the provider.
If you relax this, you very quickly start to see a pyramid structure in which there are more current rights to metal than metal itself. This leads to all the usual Minsky style instabilities.
Of course, there is nothing wrong with trading liabilities. But in a stable financial system, you would value a claim or receivable in terms of the assumption that the entity who owes you something will not receive additional financing. Otherwise there is no way to tell whether or not there is Ponzi action going on. An entity that has sold rights to deliver 200 tons of gold today needs to have 200 tons of gold today, or it is insolvent - even if everyone but you is willing to defer that delivery indefinitely. These little games of musical chairs cause only problems and benefit no one.
Moldbug,
You are of course right that monetising anything distorts its value, which is exactly why I think that both debt-backed and gold-backed systems have problems. I like the idea that money has some kind of real backing, to be regularly audited if people fear that the monetary authority are not covering all of the note issue. But a wider basket than just gold would minimise the distortions you mention.
For my own research, I would be grateful if you would refer me to any publication you know that compares the industrial and monetary value of gold.
I believe that the problem with the bimetallic system was that money was defined in terms of either x of gold or y of silver. A change in the relative value of gold vs silver then sets up a destabilising arbitrage via money. What I am suggesting is a basket where money is defined in terms of x of gold plus y of silver.
Anyway, I hope that this arcane issue is not completely uninteresting to everyone else! Its relevance to discussion of the present economy is that interest rates are dependent on our ability to model the macroeconomy, and I would doubt that such models take account of institutional and preference changes that change the relationship between interest rates and other macroeconomic variables. I suspect that such changes have undone the orthodox approach to monetary policy.
About 300-400 tons of gold are used annually, I think, in industrial processes. You can get the best current figure at the WGC’s site, gold.org. Note however that this is a fuzzy definition - there is no precise line between industrial use and jewelry use, nor between jewelry use and monetary use (much jewelry, especially in India and Indonesia, is bought as an investment).
But as an Austrian and subjectivist I believe there is no such thing as “value,” as a Platonic ideal, and no way to define it other than in terms of price. If the gold price was higher, industrial users would probably try to find a substitute. If it was lower they might use more. But there is only one market, and there is no way to calculate what the price would be if there was no monetary demand. I was just throwing out some rough and unscientific guesses, which are almost certainly wrong.
Defining money in terms of x of gold plus y of silver (let’s say, using alloyed coins as a standard) does not solve your problem. The trouble is that gold and silver can still be traded independently, and a futures market can still predict prices for both into the indefinite future. If the forward price curve between the two varies, for example as a result of changes in production cost or nonmonetary demand, one will become a better store of wealth than the other, and in consequence will be used as a medium of saving in preference to the official alloyed coins. The result will be that whichever metal loses this game is demonetized, and its role in the alloy standard will be that of a base metal.
This is one reason to prefer a monometallic standard over a multimetallic standard. In general, even from a “welfare economics” standpoint, it has less impact on the economy if you distort the market for one good rather than for many goods. And don’t forget the importance of limited supply - commodities whose supply curve is not particularly inelastic, such as copper, cannot sustain monetary overvaluation.