Brad Setser

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Almost unimaginably large (2006 global reserve growth)

by Brad Setser
March 30, 2007

Those were Robert Rubin’s words to describe the US current account deficit.   They apply equally well to the amount of dollars the world’s central banks lent to the US in 2006.   

Press coverage of the IMF COFER data has tended to focus on the fall in the dollar’s share of global reserves in the fourth quarter of 2006, something that seems largely to be the product of central banks in the world’s advanced economies.  Blame Switzerland, Sweden and Italy – though I wouldn’t be completely surprised if the Japanese were slowly reducing the dollar’s share of their reserves as well.   

The real story in my view, though, isn’t the small slide in the dollar’s share in q4.   It is the huge overall growth in the world’s stock of reserves – something that continued in q4.    As a result, the world’s central banks supplied an unprecedented amount of financing to the United States — close to $600b by my estimates, which include some things that aren't in the COFER data.

The COFER data has a few important limitations (noted by Reuters).  The COFER data only provides data on the currency composition of about 2/3s of the world’s reserves.   And because the reserves of countries that don’t report data to the IMF (China) are growing faster than the reserves of countries that do report data to the IMF, the COFER data only tells us the currency composition of about ½ the current flow.    That is a big gap.    

Moreover, the COFER data doesn’t include the Saudis non-reserve foreign assets (which increased by $70b in 2006) or what might be called China’s missing reserves – the funds China has used to recapitalize the state banks and a life insurer, along with the dollars China likely has moved off the PBoC’s balance sheet with currency swaps.   Those missing reserves – by my estimate – increased by about $45b in 2006.   

The COFER data does tell us that the world’s central banks stock of reserves increased by $853b or so in 2006, rising to above $5 trillion.     About $508 of that increase came from countries that report data on the currency composition of their reserves to the IMF, and $345 came from countries that do not.      By my estimates, about $150b of the $850 increase came from the increase in the dollar value of the world’s existing euro, pound and yen reserves, and $700b came from actual “flows.”     

$700b is a new record.   And almost all of the growth came from emerging markets.   

To come up with that estimate, I had to make a few assumptions – above all about the currency composition of the reserves of those countries that don’t report data to the IMF.   My super-secret key assumption is that those countries held about 75% of their reserves in dollars at the end of 2004, and reduced that share to 74% at the end of 2005 and to 73% at the end of 2006.   Rocket science, I know.  In my defense, though, a lot of thought and effort went into finding a simple path that matches a lot of other data. 

Christian Menegatti and I estimate that central banks added about $505b to their dollar reserves, and $200b to their non-dollar reserves, over the course of 2006.   Around $230b of the estimated increase in dollar reserves – and a bit under $70b of the estimated increase in non-dollar reserves comes from countries that don’t report data to the IMF.    Or, put a bit differently, we assumed that the countries that don’t report started the year with 74% of their reserves in dollars, and kept almost 80% of the flow (77.6% to be precise) in dollars.   But as a result of the valuation gains on their existing euros and pounds, the dollar’s share of their portfolio still fell to around 73%.

That $705b estimate for total valuation adjusted reserve growth doesn’t include the $70b in Saudi non-reserve foreign asset growth, or the estimated $45b increase in China’s hidden reserves ($40b in swaps, $5b to recapitalize a life insurer).   Throw in SAMA's foreign assets and reserves hidden in China’s banks, and the total increase in the world’s reserves, after stripping out estimated valuation gains, rises to around $820b — $590b in dollars and $230b in non-dollar. 

That is a lot.  If all $590b of the growth in dollar reserves went toward the financing of the US deficit in one way or another – a strong assumption – the US only needed to attract about $270b of (net) private financing to cover its $860b current account deficit.   It is good to have powerful friends. 

I should note that much of the $590b in dollar reserve growth clearly made its way to the US in indirect ways – central banks have dollars to private fund managers, and put dollars on deposit in Europe that were then lent out to private investors who bought US securities and so on.   But in all these cases, the currency risk stays with the central bank. 

$590b in reserve growth is a record.  It compares with $380b in estimated dollar reserve growth in 2005, and $520b in estimated dollar reserve growth in 2004 (all these calculations include all SAMA foreign assets and China’s hidden reserves).

What of q4 2006?    Well, we know that the industrial world’s central banks added –on a flow basis — $15b to their dollar reserves and $16b to their non-dollar reserves.   They clearly diversified – a 50/50% split isn’t consistent with sustaining a dollar reserve share of above 70%, especially when the dollar value of the euro is rising.    Emerging markets that do not report data to the IMF added $64b to their dollar reserves and $38b to their non-dollar reserves.   There may be some weak evidence of diversification there, but it is weak – their existing dollar share was around 60%.   Moreover, Russia accounts for a decent chunk of the reserve growth here, and we know that Russia now aims for a dollar share of around 50%.   

And what of the emerging markets that don’t report? 

I estimate that they – counting all SAMA foreign assets and assuming that China had around $15b in hidden reserve growth in q4 – added about $117b to their reserves in q4.    Keeping the dollar’s share of their reserves at 73% would have implied adding $100b to their dollar reserves and $17b to their non-dollar reserves.   

But even if they cut the dollar share of their reserves by a full 2 percentage points, from 73% to 71%, they would have added around $60b to their reserves (and $57b to their non-dollar reserves).     

I haven’t heard anecdotal evidence that China was diversifying in q4.   So I tend to think that China and perhaps the Saudis really did end up eating a lot of dollars in the fourth quarter.    But that is at this stage a hunch – I don’t have the data to back it up.

Christian Menegatti and I estimate that total valuation adjusted reserve growth in q4 – counting China’s hidden reserves and SAMA’s foreign assets — was around $250b.   If central banks who don’t report kept their dollar share constant, dollar reserve growth was around $178b.   If they scaled back, it was $138b.    Either way, it was big. 

The US current account deficit was around $200b in q4.    If countries that didn’t report held their dollar share constant, the world’s central banks could have financed nearly all that deficit ($180b to $195-200b).   And even with a bit of diversification, they likely financed most of the q4 deficit ($140b of $195-200b).    

The amazing thing?   I haven’t even worked in oil investment funds.   They received an inflow of at least $20b in q4, and even with a 50/50% split, bought another $10b of dollar assets. 

The truly amazing thing?   Global reserve growth may have picked up from its q4 total in q1.    The world’s central banks already hold more reserves than they need (US Treasury paper here), yet they keep on adding more dollars and euros and yen to their vaults.   The Brazilians are now adding about $10b a month to their reserves.  They reached $109.5b yesterday.   The Russians recently added $10b to their reserves in a single week (maybe because of Rosneft related flows?).   They are on track to add $20b in March.    China should top that, but it has yet to release its data …

I have to give credit to Dooley, Garber and Folkerts-Landau.   Events have unfolded pretty much as they expected.   Their 2003 and 2004 papers have stood up well.  Massive reserve growth in the periphery has financed growing deficits in the center at very low rates.


  • Posted by Guest

    China poised for $300 billion global shopping spree

    ” Data provider Private Equity Intelligence forecasts $450 to 500 billion will be raised this year. China’s agency, expected to be functioning by the end of the year, could increase that amount 60 percent.

    “That amount represents the single-largest pool of cash that any government has thrown at anything, ever,” according to Stratfor, a geopolitical intelligence service. “Adjusted for inflation, the United States’ largest effort, the Marshall Plan, comes in at just over $100 billion.”

    Zhou Xiaochuan, China’s central bank governor, has said the practices of state-owned investment entities in Singapore, Korea, Kuwait, Norway and Saudi Arabia could serve as models.

    Emerging markets – energy, resources and other properties crucial to the country’s national interest – are expected, as well as portfolio investments in international equity and bonds for long-term returns.

    Grace Ng of JPMorgan Chase Bank sees the investment fund going for both. The investment agency “with its higher risk appetite is expected to focus on strategic investments,” such as energy and resources and portfolio investments “tilted towards emerging market assets,” Ng wrote in a paper.

    For an energy-hungry nation like China, that would mean investment in oil- producing firms, regions and properties. The nation’s thwarted attempt to buy Unocal (now owned by Chevron (Charts)) in 2005 is an example of the resistance China has encountered in seeking obvious strategic assets in the West.

    That resistance has helped keep China’s investment focus on places like sub-Saharan Africa and Latin-America, where it has already inked deals for oil.

    In some cases, China’s investment could match its foreign policy and strategic goals. In others cases, a strategic or geopolitical reward may outweigh the investment’s loss.

  • Posted by Macro Man

    Let’s cut to the chase.

    MM: These guys need to quit buying so many reserves, they’re amplifying imbalances.

    DC: No they’re not.

    FWIW, Brad, Jon Anderson reckons that some of the ‘missing reserves’ actually represents capital outflow from China…specs taking profit?

    On a longer term what point does the money get spent? CB reserves now total $830 or so for every man, woman, and child on the face of the planet. Ay caramba!

    The really interesting thing for the investment agency is how quickly they can attract talent and deploy capital. It will probably take some time before the PIC money actually starts hitting the tape, at least from a private equity perspective. They’re much more likely to start with conventional assets (GIC) and then slowly branch out into PE (Temasek.)

  • Posted by Gheorghius

    BS, thanks for your excellent micro-work on official reserves (R).

    (Bad) politics seems to play a role now in some CBs’ strategy to further increase already high R:
    a) They are keeping their exrates low (same old mercantilist approach: “more export is good for growth”: but how many participants in this blog, unfortunately, think in the same mistaken way?)
    b) Holding more R make CBs “powerful”: political economy theory should help us explain their behaviour.

    Having said that, it’s also probably wrong to generalize. Each CB may have its own reasons to increase R, and not always a bad one. I have long argued in favour of China’s development strategy – but now they’re going too far! Inertia?. Asian CBs in general are still shocked by the 1997 crisis. Brasilians and Russians are too, and they run truly unstable not very diversified, commodity dependent economies. The same with oil producers: they know they manage an exhaustible commodity, whose price cycle is probably topping, so their behaviour (on reserves) looks quite rational.

    Fortunately, markets have a great ability to self-regulate, the US debt is not high, and global financial markets have grown further in recent years. The dollar slide is working to correct global imbalances: none too soon, but neither too late!

  • Posted by Dave Chiang

    Markets are not self-regulating with a gradual correction of imbalances; as we have seen in past equity market bubbles and the unfolding mortgage finance fiasco, the wheels often come flying off in a crash. We have gone way beyond the point where the Global Economic imbalances can be resolved painlessly with a US dollar devaluation. Sure the US dollar has devalued versus the Chinese yuan, but China’s manufacturers will remain super competitive because they’re becoming more efficient. The latest semiconductor, steel, and automobile factories in China utilize state-of-the-art technology.

    Unfortunately, the only cure for the global credit bubble was to have never allowed it to inflate to extremes in the first place. There are too many absurd MacMansions in the US Economy just as there are too many factories built in China’s economy. It is now only a question of how bad the post-bubble contraction from the global capital misallocation will become. I suspect we are in for a frightening ride. There is no easy way out.

  • Posted by RebelEconomist


    I would like to add my thanks for the information you provide, without which I would undoubtedly miss many developments in reserves. I was especially interested to read about yesterday’s US Treasury paper. As usual, they do not apply the same reserves adequacy standards to the US! We may not agree about the need for reserves here, but at least we discuss it (incidentally MM, how long could you live on the $830 that you find so large?), whereas the official US mind does not seem to even consider it for an instant.

  • Posted by bsetser

    MM — As you no doubt have deduced, I am a big fan of Jon Anderson’s work. On this particular point, though, I side with Stephen Green of Standard Chartered and the Goldman China team (they estimated a large increase in the PBoC swap position). The data pretty clearly shows that the CAS + Net FDI inflows was far larger than valuation adjusted reserve growth. That allows for two conclusions — private outflows (i.e. Jon Anderson’s profit taking) or private outflows that reflect, in various ways, state policy (PboC swaps with the banks which allow the banks to buy $ bonds but avoid RMB/ $ risk; government encouragement of state pension funds/ life insurers to increase their foreign assets, etc). Here, i think the anecdotal evidence, plus the run up in Chinese asset markets, works against the “hot money moved out of China thesis.” But there is a real debate. I should have linked to Stephen Green’s latest in Business week to support my point, but I was lazy.

  • Posted by Macro Man

    Brad, the capital outflow story (from Chinese entities)would be somewhat easier to swallow if takeup of QDII quotas was anything more than paltry. Admittedly, currency risk is a part of the reason for QDII’s failure, but then again the famous one year swaps locked in an FX rate that more than eroded any yield pickup rfom buying US paper over domestic paper.

    RE, how is it relevant how long I can live on $830? And why do you believe that more, rather than less, official intervention in markets is a good thing?

  • Posted by Guest

    As their U.S. exposure increases, CBs are naturally concerned about diversifying into other currencies. U.S. current account deficits presumably will continue for some time. CBs will likely feel the need to continue policies of recycling a large part of these deficits. Therefore they face the problem of somehow diversifying a concentration exposure whose absolute size will nevertheless continue to increase. This means they must expand their non-dollar portfolio content at a greater pace than their dollar content, which continues to grow.

    Perhaps the implication, as a relative order of magnitude, is that CBs in aggregate are under increasing pressure to add to their total currency reserves at a pace that approaches or even exceeds the annual U.S. current account deficit on an ongoing basis. This takes into account the need for CBs to fund a considerable portion of the dollar requirements of the U.S. deficit, while at the same time continuing to expand the non-dollar content of their portfolios in order to achieve better diversification.

    This seems inherent in your general observation and in the detailed numbers you cite/estimate. It means that, while their own current account surpluses remain the primary reason for aggregate CB reserve accumulation, diversification is additionally important, not only for asset mix objectives, but for the resulting size of total reserves as well.

  • Posted by bsetser

    Macroman — the capital outflows from China aren’t really in question, the h1 BOP data showed $40 or $45b (I forget) in “private” purchases of foreign debt (portfolio securities debt in the BoP). The overall 06 BoP only works if something similar happened in h2 (the formal data isn’t out). Think a CAS of $230b, net FDI of around $60b and valuation adjusted reserve growth of around $220-230b (I don’t have my formal estimate on my finger tips). The BoP only balances with a net $60-70b in capital outflows. the question is who was the source of the outflows — state institutions, state commercial banks or private savers. I think the meager take up of the QDII and the continued fall in domestic $ deposits suggests private savers preferred Chinese assets, which implies state institutions or state commercial banks. I forget the terms of the swap, but i think that it basically gave the banks $ at a decent interest rate — the real goal was to mop up domestic liquidity — and allows the banks to make money as intermediaries. certainly, as Fitch reported, there was strong growth in the banks foreign assets.

    Guest — I am not sure that the casuality is quite as you describe it. I cannot quite see a FCB saying ok, we have $700b in $ and we are adding $200b to our dollar reserves a yuear and will need to for some time so let’s offset our $ exposure by adding to our euro exposure and increase the pace of our reserve growth. Your dollar exposure is still growing — so that risk isn’t going away, and you just end up adding another concentrated euro position. and most big reserve holders will appreciate over time v. both the $ and euro. you can certianly make a case that the RMB/ euro is more out of line than the RMB/ $ (RMB has depreciated v. euro significantly in the past five years).

    I find macroman’s description of the casuality more convincing. some countries find their reserves (really foreign assets in state control — a definition that includes national investment funds) growing rapidly, whether from a dollar peg or a commodity shock. they conclude, hey, maybe we don’t want to hold all our wealth exclusively in $. They also conclude that they want to maintain their dollar pegs. shifting some assets from $ to other currencies tho puts a bit of pressure on the $ (at least in periods when private demand for $ is modest), which means their real effective exchange rate falls. And that induces either a bigger trade surplus or more capital inflows looking to profit from the expected revaluation v. the $ … and so on.

    To my mind, what counts is the absolute size of your $ position. If it is growing, your exposure to a $ depreciation is growing independently of what else is happening with your portfolio.

  • Posted by RebelEconomist

    Macro Man,

    One purpose of foreign exchange reserves is as a shock absorber in case of some payments crisis (eg the “sudden stop” of the international economics literature) in which the country cannot borrow or export for a while……ie not for currency intervention per se. Even $830 per person in the US – not that the US has that much in reserves anyway – would cover less than two months of its normal imports. The usual standard quoted – eg by this weeks US Treasury paper is three months.

    You probably find it inconceivable that the US could ever need such a store of precautionary savings. As Guy de Jonquieres noted in Thursday’s Financial Times, English intellectuals thought in 1913 that war in Europe was inconceivable, because countries had become too economically interdependent. The subsequent war transformed Britain from the world’s greatest creditor nation to practically bankrupt in four years. You never know.

    Of course, it is necessary to sell dollars to acquire the reserves, which can be characterised as intervention. But such a transaction is really just part of prudent management of the public finances which other countries would have to accept. I would argue that by not maintaining its reserves at a level of effectiveness that it thought justified itself when it was less indebted, the US government has contributed to the imbalances itself. Think of the US government as being long dollars and short foreign currency relative to its benchmark.

  • Posted by Guest

    I’m not sufficiently knowledgeable on the individual central bank positions or currency correlations, to argue my idea better on a pragmatic basis. But just to add a bit in concept, if the primary problem is the absolute size of U.S. exposure, there is an alternative to selling down the dollar portfolio in exchange for other currencies. CBs could simply sell U.S. dollars for their home currency, reversing monetary base effects as appropriate with the purchase of domestic debt. (Reserve ‘wealth’ held by a central bank is net of the sterilization offset, and to that degree, a discretionary notion.) Or, they can simply not buy as much in the first place. Either way, there is marginal downward pressure on the dollar compared to the status quo. It would suggest that CBs hold more U.S. reserves than necessary to implement their policies on pegs, etc., and they really don’t need to diversify as part of the solution to the problem of U.S. exposure per se (I was referring to CBs in aggregate). It implies further that foreign exchange risk exposure per se is not the primary reason for diversification of the currency portfolio. (For example, if the RMB/ euro is more out of line than the RMB/ $, replacing dollars with euros would seem to increase portfolio foreign exchange risk in the long run). Perhaps there are other reasons to diversify apart from a potential reduction in portfolio foreign exchange risk (through expected covariance effects) – more positive reasons associated with the benefits of holding other currencies in their own right?

  • Posted by moldbug

    One exercise that may make this strange situation easier to understand is to imagine, for a moment, that the world’s CBs are operating as a single institution – a sort of Cartel.

    Under this perspective all notes issued by one CB and held by another are meaningless. They net out, like the Social Security “trust fund.” They are certainly still part of the Cartel’s internal decision-making process. But when we analyze any institution, we ignore internal commitments and focus only on external ones.

    So the PBOC says it will sell dollar bonds and use the proceeds to buy other assets. Or at least, in future when it buys dollars for RMB, it will spend the dollars, or at least some of them, on something other than dollar bonds. In whatever case, if there is an actual policy change here, ceteris paribus it implies a relative increase in the supply of dollar bonds and a relative increase in the demand for other assets.

    From our outside-the-Cartel viewpoint, whether this action is taken by the PBOC, or by the Fed or Treasury, is entirely irrelevant. The point is that dollar bonds are being sold and other assets are being bought.

    Imagine how we would react if President Bush announced that the US would take on more debt in order to buy up the stock market. (Or the metals market. Or the oil market. Or (yes, RE) the euro, yen and pound.)

    But this is not the end of the story. Because we can look at the market for dollars of all maturities as a general case of the market for present dollars, selling dollar bonds (future dollars) should drive down the exchange rate between the dollar and all other goods. Including of course other currencies.

    Including the RMB, the Brazilian real, etc. All currencies which are pegged to the dollar. So the more dollar bonds the Cartel sells – again, whether the seller is the PBOC or the Treasury – the more it has to buy.

    The problem is the pegs. “Diversifying” solves nothing. The net result of “diversifying” is to simply increase the supply of dollar-pegged currencies, and increase the price of all assets which are demanded by people who hold those currencies.

    This is a destabilizing outcome, not a stabilizing one. If it wants to “cool” its “overheated” economy, China should hold onto those T-bills.

  • Posted by RebelEconomist


    You refer to my comments, but I must confess I find it hard to understand what you are saying. That is probably because, as I have admitted in previous contributions, it is not clear to me how monetary and exchange rate policy actually works. I think I agree that it would be inconsistent for China to try to sell dollar assets while maintaining its peg, but I am not sure whether what the effect on the dollar of selling financial dollar assets for real dollar priced assets would be. Anyway, it seems to me that it does not have to be economically destabilising if indebted Americans sell the Chinese some real dollar priced assets that will produce a stream of valuable output in future. For example, if the US allowed China to buy Alaska in return for cancelling its entire claim on the US state, economic relations could return to square one. The problem is of course political.

    I am sorry if I misinterpret what you mean, but you need to explain things in very simple terms for me!

  • Posted by Guest

    ” The problem is the pegs. “Diversifying” solves nothing. The net result of “diversifying” is to simply increase the supply of dollar-pegged currencies, and increase the price of all assets which are demanded by people who hold those currencies. This is a destabilizing outcome, not a stabilizing one. If it wants to “cool” its “overheated” economy, China should hold onto those T-bills ”

    Thanks – quite helpful in the ‘global’ view of money and the ‘cartel’.

    I lean towards isolating domestic interest rate risk from exchange rate risk in the analysis as much as possible, by assuming for convenience that CBs initially deal in 1-day bonds (separating domestic interest rate risk from exchange rate risk and assuming switching from 1-day bonds to term bonds (you make this transition seamlessly)).

    The sale of foreign currency bonds by any CB then expands the global asset (1 day-bond ‘money’) supply in foreign currency, and drives up price levels in that currency for all other demanded assets. This would apply if PBOC sold U.S. bonds and replaced them with Euro reserves, or if the Fed bought Euros for its reserves, and sterilized them with U.S. bond sales. Both transactions would ease U.S. dollar monetary conditions while tightening everything else, on a relative basis.

    My original comment under this topic was that such effects might depend on net cumulative central bank intervention – i.e. as measured by the size of their reserves – the degree to which they’ve interacted with the free market on a cumulative basis.

    With reference to the specific (hypothetical) example of switching PBOC asset mix from dollars to Euros, the effect may vary depending on the starting point for the PBOC balance sheet.

    Suppose the balance sheet is in a certain condition (call it ‘E’) where the peg seems to be in a state of momentary ‘equilibrium’. Then switching dollar reserves to other currencies should produce the effect as described by both Brad S. and yourself, and that you have characterized as quoted. I agree. This type of ‘diversification’ seems not to accomplish much, at least in terms of it being counterproductive for the peg.

    But suppose the balance sheet is increased from size E. The purchase of U.S. dollars is followed by their sale for Euros. The first stage disrupts the momentary ‘equilibrium’ – i.e. depreciates RMB from peg. The second stage revalues it, at least directionally toward peg. (I’m unsure here – I derive slightly different interpretations, perhaps erroneously, from reading Brad S. and yourself.)

    Thus, if ‘diversification’ is executed without net decreasing CB holdings of U.S. assets, there should be less net depreciation effect on the U.S. dollar from the perspective of either the PBOC or the global ‘cartel’.

    Hence my original comment point that central banks may be ‘diversifying’ currency exposure with this in mind – expanding their reserves at a pace faster than what is actually required to maintain the peg. As to what diversification accomplishes otherwise, if anything, I haven’t addressed.

  • Posted by Anonymous

    You hedgies should take all your carry trades, CMO tranches and Sharpe ratios and throw ’em out the window. It has been easy money in the world of unlimited credit, but the risk spreads are about to widen. Subprime is the canary in a coal mine. Smart hedgies will be turning tail and getting on the other side of the trade. It will be very easy money when it all breaks loose. Or, keep all those highly leveraged trades and have ’em blow out all your equity.

  • Posted by moldbug


    I was just referring to your intriguing idea that the US should counter foreign currency manipulation by counter-manipulation (accumulating its own reserves, whether of the peggers, or of the G7 deadbeats who refuse to share the (Harry Dexter) White man’s burden). I’m not sure if this idea computes politically, but from a strictly economic perspective it sure beats the hell out of tariffs.

    As for understanding monetary and exchange policy, if you did you would probably be the only one. This would presumably enable your rebellion to succeed and become the new Empire. I understand the social obligations of an Imperial Economist are quite onerous, so you should perhaps watch what you wish for.

    Guest, there has been a spate of perspicacious comments under your name lately – if you used a handle it would be easier to categorize them.

    In general I agree with the above. It is probably a better wording than mine and in fact I think my “cartel” perspective may have been inspired by a comment of yours earlier on. I like the way you factor out the yield curve – there presumably is still some “natural” or endogenous yield curve, that is based on actual time preference in the Austrian sense, lurking out there behind all the CB-injected noise.

    The summary that “diversification” without abandoning or weakening the pegs just means more CB accumulation of non-dollar assets, and does not affect (global) CB accumulation of dollar assets (larger E with constant D, one might say), strikes me as essentially sound.

    Of course, from inside the Cartel the view is very different. Just because we can, from outside the Cartel, analyze the Cartel as a black box by ignoring the motivations for its actions, doesn’t mean no such motivations exist.

    Assuming that CBs do care to some extent about the long-term value of their portfolios, the appeal of various financial stunts that allow your own CB to end up with Real Stuff ™ and force all your fellow peggers to wind up with Green Paper ™, is obvious. Diversification thus does represent defection in a sense. It’s just that (a) if everyone does it, no one benefits and everyone is harmed, and (b) anyone can do it.

    Given the fact that everyone who works for a national CB is (a) smart, (b) well-intentioned in both a local and global sense, and (c) tends to have pretty good contacts with everyone else who works for a national CB, one would hope that this pattern could be nipped in the bud.

    Of course the ultimate form of defection would involve anticipating the demise of BWII and its replacement by a new global monetary standard. Thus rather than buying up Real Stuff in general, the ultra-defection strategy would focus on trying to identify potential BWII successors and exchanging dollars, presumably nontransparently, for these assets.

    BWII is certainly a deformed monstrosity, but this would be a very painful and ugly way for it to expire, and I would certainly hope a more collegial form of euthanasia could be found.

  • Posted by Gamma

    Moldbug – I appreciate your insights.

    Anon – you wrote: “You hedgies should take all your carry trades, CMO tranches and Sharpe ratios and throw ’em out the window. It has been easy money in the world of unlimited credit, but the risk spreads are about to widen. Subprime is the canary in a coal mine. Smart hedgies will be turning tail and getting on the other side of the trade. It will be very easy money when it all breaks loose. Or, keep all those highly leveraged trades and have ’em blow out all your equity.”

    HA! Agreed. I’m looking forward to the trading bloc of the finanacial industry being reduced by half. Interpolate all you want, but extrapolate at your own risk!!!

  • Posted by RebelEconomist


    What I am proposing is not intervention or manipulation per se, it is SAVING. I presume that you and Macro Man are American, so you may need to look the word up!

    As you say, tariffs are a bad way of dealing with imbalances. Actually, given that the US is, at inter-government level at least, mainly complaining about China’s exchange rate policy implemented through dollar asset purchases, if America must introduce some restrictions on China, it might be most appropriate to restrict what it is allowed to purchase from the US, rather than what it sells. Perhaps the US could set some limit on China’s purchases of financial assets. Then China could choose itself whether to restrict its exports to the US, and which items specifically, or whether to find some particular goods and services in which to boost its purchases.

  • Posted by jkh


    I’ll revert to my previous ‘handle’ now. Thought I’d lie down and bleed for a while, under the cognomen of ‘guest’, given marginal evisceration arising from gross displays of ‘bookkeeping’ in central banking – ironically, an earlier response to RE. Better to be quiet for a while, and learn large from someone with an entirely different perspective.

    I’ve downloaded ‘Crises and Cycles’. The excerpt you included was astonishing in its ‘history rhymes/repeats’ quality. I haven’t really explored the Mises site yet, but I also downloaded ‘Pure Theory of Capital’ by Hayek while I was at it. Hope to explore portions of these at least, in the near future.

    RE, I found your reference to Alaska interesting. It reminded me of a Greenspan speech a few years ago, referring to the range of things that a central bank could ‘monetize’ if ‘necessary’ in a deflationary environment. And the initial conversation where Moldbug described an implicit / contingent option structure for the assets and liabilities of a central bank, given its power to monetize. Finally it reminded me of a paper I wrote long ago (not published, or up to any standard of publishing), exploring a corresponding conceptual range for the Bank of Canada, including Baffin Island. My conclusion then was that the economic textbooks had it totally wrong, and logically backward, in their description of ‘fractional reserve banking’. This was reinforced in my own mind later on, when the Bank of Canada eliminated reserve requirements (about a decade ago).

    Because of my background, I’m fascinated by the intersection of economic theory with central banking operations (little classroom training in economic theory / meaningful encounters with commercial banking and central banking).

    My mansion of ignorance includes Austrian economics. Encountering snippets over the years, I’m fascinated by what I understand to be its emphasis on time. Although having read virtually nothing, my instinct is that there may be a natural connection with option mathematics and risk theory. Given my lack of training, I find the topic of gold to be extraordinarily frustrating to understand at the money level, and ever more so, given its obvious importance.

    Brad S. – an extraordinarily interesting Blog. Because of the 14-day trial, I paid close attention, and am pleased to continue basic access.

    Pleasant evening to all.

  • Posted by Anonymous


    Government actions and market participant greed trump market efficieny during bubbles. The liquidity bubble is no different. As manias progress, profiting from these inefficiencies attracts many into the cowboy life. It is a very good life. Alas, the greenhorn pretentious types like to drink their own extrapolation flavored Kool-Aid and ride past the big neon sign reading, “Inflection Point Ahead!” Take heed, the coil is wound too tightly. The worthless subprime paper has given the world a glimpse into the absurdity. Contagion is a misnomer. Risk being mispriced is a misnomer. Simply stated, there is a lot of worthless paper floating around. This paper must and will go on its inevitable search for a bagholder. The mini correction of a few weeks was but a stirring.

  • Posted by moldbug


    Thanks – please bear in mind that you (and not only you) are educating me at least as much.

    For someone with your background I think probably the best three Austrian books are Theory of Money and Credit (Mises’ original, 1912, revised in the ’20s); Money, Bank Credit, and Economic Cycles (de Soto, a very comprehensive history of fractional reserve from a modern Austrian perspective); and Man, Economy and State (for the classic taste of Rothbard, sort of the Laphroaig of Austrian economics). All three are free in PDF on line from the LvMI.

  • Posted by Macro Man

    Oh dear, oh dear. To quote the Black Eyed Peas (surely a first on the Brad S. blog!): “where is the love”?

    I am curious as to why there is an embedded assumption that all hedge funds are myopic, coupon-clipping fools. While there are clearly a number of strategies (fixed income RV, CB arb, etc) that have coupon clipping and ‘normality’ embedded, good fund are buyers, rather than sellers, of risk premia. Not to dredge up old wounds via-a-vis the yen carry trade, but there was a blurb in the Nikkei today about how the stock of foreign currency assets of Japanese households rose by 20 trillion yen between September 2003 and December 2006. It’s still a pittance (2.5%) compared to financial assets, however…so is this a carry trade, or a responsible portfolio diversification?

    RE, while I have enjoyed sparring with you (though I fear we may have to agree to disagree on the utility of a new US accrual of reserves), I must confess to some degree of concern over your welfare. The evenings in the UK are still quite chilly, so I can only hope that you glass house is well-insulated? While dissaving in the UK is admittedly not as bad as in the US, the accelerating trend of both the current account deficit and rising prsonal insolvencies does suggest a problem, while household leverage is strikingly similar to the US. Good thing we in the UK have Gordon Brown to look after our pensions!

  • Posted by RebelEconomist

    Macro Man,

    I can agree to disagree; I just wanted to make sure that my case – that the US is unusual in not maintaining reserves – is not misunderstood.

    I agree totally about the UK, although I do not normally bring it up as the UK is a relatively minor player. So much of what applies to the US applies here. We are mad about houses – every newspaper has a property supplement, every night there is a property programme on TV. People are reluctant to save. We have received reserve inflows, have not increased our own reserves, and have a current account deficit. Interest rates err on the easy side. The measure of inflation is manipulated. Education for the majority is poor. I could go on. The one area where I think we do better is that the British are less protectionist.

    Fortunately though, we have an atmospheric greenhouse with no glass, which we began to build but is now maintained for us by the US, so the weather here today is lovely!

  • Posted by Macro Man

    Yes, I’d concur that Britain is less protectionist. The punitive taxes here are inward looking, rather than outward-looking ;). Your’re right about the weather though…I’m just hoping it holds up over the long weekend!

  • Posted by RebelEconomist


    It sounds like you are on a similar path to me in your interest in the nexus between economic theory and central banking operations. You might like Ulrich Bindseil’s book on Monetary Policy Implementation, published by Oxford University Press.

  • Posted by Guest