A little too late …
China's premier, Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness. Cheng Siwei comments two weeks ago seem to reflect rather widespread worries among China's top leadership. The FT reports:
Premier Wen Jiabao told a business audience in Singapore it was becoming difficult to manage China’s $1,430bn foreign exchange reserves, saying that their value was under unprecedented pressure.
“We have never been experiencing such big pressure,” Mr Wen said, according to Reuters. “We are worried about how to preserve the value of our reserves.”
China keeps the currency composition of its reserves a state secret, but some analysts believe that more than two-thirds are probably still held in dollars.
Wen certainly has reason to worry. No one has made a bigger bet on the dollar that China's government. I personally suspect that China's state — counting the assets of the State Administration of Foreign Exchange, the China investment corporation, China's big state banks and the national social security fund — hold around $1.2 trillion in fairly long-term dollar-denominated debt. The precise number depends on just how many dollars the banks are currently holding (their holdings of foreign debt securities likely are well over $200b by now) as well as just what fraction of China's roughly $1.5 trillion in formal reserves (China had $1433.6b at the end of September and is steadily adding to its reserves) are in dollars.
The capital loss on those dollars could be considerable. The dollar hasn't held its purchasing power relative to the euro, or relative to oil. But what should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB. After all, China's government has financed its dollar purchases by issuing RMB debt. Willem Buiter argues:
If the dollar falls by another twenty or thirty percent, which is certainly possible, the Chinese and Japanese authorities would each be presenting their tax payers with a further $200bn to $300bn capital loss. That's a heavy price to pay for access to US markets for your exports, especially for a poor country like China
I have a feeling that the current (unrealized) mark-to-market losses on China's investment in Blackstone drew attention to the broader financial risks that China is taking by holding so many foreign assets. China's large holdings of dollars clearly pose a far larger risk than its small stake in Blackstone.
Moreover, the Hu/ Wen policy of only allowing gradual RMB appreciation — out of fear that fast appreciation would be disruptive — largely explains why China now holds so many dollars. Back at the end of 2004, China's total reserves were only around $600b ($650b counting Huiijin) and the state banks held a lot less long-term dollar debt. China's total dollar holdings were more like $450-550b.
The majority of China's dollar exposure comes from intervention over the last three years.
That puts Wen in a bit of a bind.
His comments were no doubt intended to tell Washington that it need to start paying more attention to the value of the dollar.
Yet domestic US conditions likely call for the Fed to cut rates to support the US economy, not raise them to defend the dollar. The market now expects a series of rate cuts. Ten year Treasuries yield close to 4%.
As Paul Krugman notes (hat tip Thoma), the "arithmetic" doesn't suggest that dollar weakness will contribute that much to inflation. Imports are still a relatively small share of US GDP and a fall in the dollar doesn't necessarily translate one for one into higher US prices for imported goods. The absence of a stronger link between dollar weakness and inflation makes it hard to build a strong case that the Fed should target the dollar rather than domestic variables.
Wen cannot force the US to direct its policy at defending the dollar's external value anymore than the US can force China to stop intervening in the foreign exchange market.
He could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China's dollar portfolio.
But doing so would truly cause the dollar's value to tumble. It would dramatically reduce the value of China's existing dollar holdings. As importantly, it would — absent a change in China's currency policy — also push the RMB down and push up Chinese inflation.
No wonder Wen is unhappy.
Many of the risks that Dr. Roubini and I highlighted in our rather gloomy 2005 paper seem to be very evident now. The US slowdown has brought a lot of latent tensions to the surface — in the Gulf (see today's Slater/ Cummins article) as well as in China. Willem Buiter is worried about a scenario where foreign demand for all US bonds — not just demand for CDOs and riskier bonds — disappears. He writes:
"all the ingredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood"
And, as Menzie Chinn notes, the US hasn't locked in low interest rates in dollars forever. What if the US turns out to be borrowing at what amounts to a low initial teaser rate?
To be clear, Bretton Woods 2 has not yet cracked. Asian central banks and state oil funds likely provide the US with far more financing now than a year ago, let alone two or three years ago. The US didn't slow down because foreign creditors lost their appetite for US debt. Rather, a US slowdown led foreigners to lose their appetite for risky US debt. The interest rate on Treasuries is still quite low.
But a system where the Gulf, China and some other Asian economies intervene heavily in order to resist market pressure for appreciation — after all, they have depreciated by almost as much as the US against Europe — is under a lot of strain. Both China and the Gulf are starting to worry about the all the (depreciating) dollars they now have to absorb to sustain the system, even if they haven't actually balked at buying those dollars.
It consequently really shouldn't be a surprise that a range of countries are now asking the US to take policy actions — notably steps to defend the dollar — that will reduce the strain that the system places on them.
But granting their wish would effectively change the nature of the system. Up until now, Bretton woods 2 provided the US with unconditional financing, not just cheap financing. Foreign central banks built claims on the US even thought the US wasn't committed to protecting the dollar's value.
In some sense, the current system seems poised at a knife's edge. That may be a bit too dramatic, but probably only just. After all, the sober FT is warning of the risk of a dollar rout.
There are a set of investors — China's government, Japan's government, some large oil exporters and for that matter most domestic US investors — that are significantly overweight US financial assets. That conclusion is true relative to any relevant benchmark, at least for the big Asia holders of dollars, the Gulf and some smaller oil exporters. You can at least argue that US investors should hold most of their wealth in dollars to limit their currency exposure.
If those investors with lots of dollars decide that they already have to many and try to reduce their dollar holdings, watch out. The dollar could fall even further. Indeed, all it would really take is for the big current buyers of dollars to decide to stop adding more dollars to their existing dollar heavy portfolios.
On the other hand, the dollar has already fallen rather substantially against most European currencies. The US/ European trade balance is already falling — and that is more from a dollar at 1.30 to 1.35 late last year than the dollar's current weakness. At some point investors who are holding lots of euros or pounds might decide that the dollar is cheap. And for that matter, some investors who are already dollar heavy might decide that at this stake, they should double down. China should have bought more euros back in mid 2004 — or much of 2005 — at around 1.20. But 1.45 (now almost 1.48) isn't 1.20. Maybe the right strategy for China and other big holders of dollars now is to sell euros and buy dollars to raise the dollar share of its portfolio in the hope that the dollar will rally v the euro …
I am not sure which outcome — at attempt by those already over-weight dollars to lighten up, or a decision by others that the dollar already has fallen by too much against the euro — is more likely. I can see the case for both, though the absence of any real signs of resurgent demand for US financial assets suggests, at least to me, that there is a slightly higher chance of even more dollar weakness.
By contrast, I am pretty confident that it doesn't make sense for the dollar, the riyal, the dhirham, the RMB and a few other Gulf and Asian currencies to all have depreciated by nearly as much as the dollar against the euro …
Just think how much better off we would all be now if they had taken advantage of the dollar's 2005 rally to move more decisively off the dollar.
Aha, the Wile E. Coyote moment approaches….
Thank God for countries which will trade goods and (precious) oil for fast depreciating paper. Party on America, the foreigners have not figured out how to get off the treadmill they are on!
The feckless attitude of US Treasury Dept officials towards the US Dollar collapse has been, “It’s our currency, but your problem”. WRONG.
In case Paulson and Bernanke have forgotten Economics 101, the foundation to any market economy is “sound money”. The biggest loser from the reckless US monetary policy isn’t the Chinese PBoC, but the American economy. Instead of investment into the “real wealth” producing economic sphere, capital has been massively misallocated across the US Economy. For destroying the monetary puchasing power of the US Dollar, Paulson and Bernanke deserve to be fired from their respective jobs.
You can blame Washington and the Pentagon also for this wonderful dollar mess. Bernanke and Paulson inherited the house of cards and are just making it worse. The Chinese are starting to feel the pinch and are waking up to the fact that the dollar may not have a bottom.
Brad,
I would like to see you write an article speculating about how the Chinese might have managed their money differently. I’m unclear as to what their alternatives might have been. Assuming they grow their economy primarily through exports to the US, don’t they basically have to accumulate excess dollars? Exactly what other financial markets are liquid enough to absorb 1.4 trillion in investments anyway – Brazil? IOW, China has to own USD, which in turn has to devalue. That’s the price they must pay for using low wages and low regulations to growing their economy at the expense of the US manufacturing base.
Guest — the obvious way for China to have managed its money differently is for China to have managed its economy so that it has less money to manage. Moving to a real basket in 05 and having a faster rate of crawl v. that basket back in 05 and 06 might also have facilitated holding fewer $. But I basically agree with your bigger point — right now, only the US and Europe can absorb a meaningful share of China’s $500b in foreign asset growth. China is trying to invest some in other markets at the margin, but it is still i think at the margin …
Seems like the depositors are pressing hard the FED to stop lowering rates.
Noone cares about a small recession, even a US in recession must import oil and electronics!
Bernake and Paulson are doing the best with the fiscal situation that they have gotten. The root causes of the drop in the dollar is an administration trying to fight a major war without increasing taxes. Once you have this fiscal policy in place, there is very little you can do with monetary policy to fix it.
Personally, I don’t think that there was much of an alternate way that China could have managed itself out of this situation. The situation really started in 2003, and spending five years to change the financial system so that it could handle a floating dollar exchange rate was I think the least bad of the alteratives. What is likely to happen now is that China is going to accelerate RMB appreciation, and start using the now valuable RMB to make huge purchases of assets. The interesting thing is “what happens next.”
The place that I think the sparks are going fly is not with the RMB. If the dollar appreciates sharply against the yen, then you are going to see an unwinding of the yen carry trade, which is going to be very interesting.
Guest,
Instead of “real” investment in high technology industrial production, why did the US government monetary authorities actively promote an “asset bubble” in Housing that has massively misallocated capital. Greenspan even advocated Americans speculate in Housing by taking exotic zero downpayment and adjustable rate loans. Why did US Treasury and Federal Reserve officials permit Wall Street subprime toxic waste CDO’s to be marketed as AAA-rated bond securities? The entire deregulated US Economy reeks of Enron-style criminal behavior!
China’s problem with the dollar is China’s fault, for two reasons. First – it is the RMB dollar peg that resulted in the accumulation of dollars in the first place. China leadership isn’t stupid. Surely they saw the risk in the building US current account deficit and their role in nurturing it. Second – and in acknowledgement of the first issue, is the fact that China had every opportunity to diversify much more aggressively out of dollar holdings long before their current ‘crisis’ got to this stage. This result simply reflects very bad foreign exchange risk management on the part of China – concentration risk rather than diversification. The result is that China is overexposed to the US dollar and most of the rest of the world is effectively underexposed. They can whine about it all they want – but this problem is their own doing at the end of the day. Bad, bad risk management. You don’t react in an attempt to rebalance an overly concentrated risk position after the horse is out of the barn.
Brian:
Thanks for your response. Certainly the creation of the Euro has at least created a “currency” that is liquid enough to be considered as a viable destination for an investor of China’s unique size. However, remember they have to use that currency to invest in Europe’s “capital markets” which remain balkanized and relatively illiquid. Don’t underestimate the difficulty of moving that amount of money around in a provincial marketplace. Of course China should continue to diversify away from the dollar as much as they can, but I don’t think the percentages will change that much. They are accumulating new dollars faster than they can reasonably move into other viable investments.
They are caught in a dollar trap as it devalues, especially since any quixotic attempt to move aggressively into the Euro will almost certainly destroy the value of their remaining dollars before they have finished converting even a small fraction.
Chinese Monetary Authorities Crackdown on Illegal flow of Capital
http://www.atimes.com/atimes/China_Business/IK21Cb03.html
HONG KONG – The Chinese government has delivered a “clear and loud” message through the state-run media that it will clamp down on the illegal flow of funds that enter Hong Kong via underground financial institutions based in neighboring Shenzhen.
Beyond the threat to the economy, illegal fund outflows also jeopardize Beijing’s plan to gradually open the gate to legal outbound investment, analysts say.
The government this year expanded the scope and quota size of its qualified domestic institutional investor program, which allows residents to join funds for investment in overseas capital markets, particularly Hong Kong with its heavy concentration of mainland-focused stocks. The presence of large quantities of illegal funds driving up the Hang Seng Index would cause any rational fund manager to think more than twice before joining the same market, analysts say.
This is one reason the government has put a brake on the so-called “through-train” program that would allow individual mainlanders to directly trade in Hong Kong stocks. Beijing is afraid that they too would be victims if the market took a sharp downturn.
From this perspective, analysts say, Beijing’s campaign to crack down on illegal activities is to support the legal outflow of funds for the healthy long-term development of the Hong Kong stock and property markets.
Guest — true enough. And it isn’t obvious to me that shifting to euros at the current $/ euro rate helps China all that much. the RMB should appreciate significantly over time against both the dollar and euro.
Anonymous:
“You don’t react in an attempt to rebalance an overly concentrated risk position after the horse is out of the barn.”
I agree.
But I also think that there is a risk — tho one that is hard to quantify — that China will react to an overly concentrated risk position at exactly the wrong time. China’s leadership is quite smart and should have realized the currency risk that they were taking. But I am not sure the very top really focused on this problem until recently. Certainly the public outcry over blackstone losses focused their mind, in part b/c the CIC clearly doesn’t want to be holding the $ risk and thus “responsible” for losses. And somehow i suspect that China’s leadership may not have seen the United States economic weaknesses quite as clearly as some, and thus may be surprised the dollar’s current weakness. There was always a group inside China that thought that there wasn’t much need to change the RMB/ $ because the dollar wasn’t going to stay weak forever …
All this is total speculation. But I increasingly worry that China is only now waking up (both at the very top and the very bottom — the technocrats at SAFE and the PBoC always knew) to its concentrated risk position.
bsetser: But I am not sure the very top really focused on this problem until recently.
I’m sure that they did. The Politburo has been discussing currency policy since at least 2003. The problem is that it is a very, very difficult problem to fix, far more difficult than most economists recognize. Most economists seem to assume that the problem can be resolved by just changing the exchange rate and that “magically” solves the problem, since economists are mostly in this world of charts in which if you change one number, the other numbers magically change.
Politicians realize that the world really doesn’t work that way. Something that I’ve noticed is that people with political backgrounds in the United States tend to be far more sympathetic to the Chinese government than economists are.
The main reason I’m sympathetic to the Chinese government is what I’ve seen. Investment banks typically have thousand CPU clusters that run overnight trying to figure out what happened the previous day, and without those clusters, things would grind to a halt. Because Chinese banks have been in a fixed interest rate/fixed currency environment, they don’t have any of these reporting capabilities, and getting things to the point where a bank could figure out whether or not it made money or lost money the previous day was likely to be a big hurdle. Big investment banks have huge problems dealing with 15% shifts in currency values, and there is another 1000 node supercluster which does simulations to make sure that none of the banks positions will kill it in case of a large shift. Chinese banks which are only starting to get this technology would be dead in the water with a 15% maxi-reval.
One final thing. Politicians usually are very quiet while they are trying to figure out what to do, and they only start talking loudly when they’ve made a decision. It’s likely that the major decisions were made in the summer, and things had to wait until the Party Congress to make sure that the people were in the correct places, and the Chinese government is now in the implementation phase.
Also, shifting things into equities protects you from currency fluctuations. If you invest in a US company with international operations then the fundamental value of that company will tend to remain fixed in reaction to US exchange rates, and that will hedge out exchange rates fluctuations.
The Chinese Politburo has alot of other domestic economic issues on the table to worry about and fix before the issue of US Dollar devalaution. Rural poverty, growing income gap, unbalanced development, overheating GDP growth, rural education, environmental protection are far more important concerns. From my personal impression, the Chinese leadership is far more directly fixated on domestic and regional Asian issues. Americans like to believe that they have been anointed by God as the center of the world, and every financial decision made by the Chinese leadership takes into consideration the views of the Washington Consensus. Nothing could be further from the truth. In reality, the current Hu Jintao Chinese leadership doesn’t give its highest priority to relations with the United States. The majority of regional ASEAN +3 conferences don’t even include formal diplomatic US participation. The annual ASEAN conference at a Hainan Island resort pointedly doesn’t invite US participation. Despite the endless chatter about US led globalization, China’s relations and integration with its next door ASEAN +3 neighbors are of paramount importance. Today’s third wave of globalization, led by developing nation states of the world, largely excludes participation by Western nations. While I was in Changsha China over the past summer, an ASEAN regional conference was held to encourage greater Southeast Asian investment into interior Chinese provinces including Hunan and Henan. Frankly, I couldn’t imagine any US interest in participating in that regional conference.
Brad,
“I would like to see you write an article speculating about how the Chinese might have managed their money differently.”
I read your response to this and I wonder about Chinese domestic investment in health care, social security, and education. Why couldn’t the Chinese have done this, thereby in the long run cultivating a consumer class? Then they could begin the process of rebalancing their economy towards their citizens and away from such extreme reliance on exports. Everybody claims that the Chinese are so worried about popular discontent which is the reason for no ‘rash’ moves wrt moving away from the peg. I don’t believe this. If they were so worried about discontent they could have spent some of that wad on their own citizens.
China compaining about another currency being devalued too much. How ironic.
Twofish,
You say “The place that I think the sparks are going fly is not with the RMB. If the dollar appreciates sharply against the yen, then you are going to see an unwinding of the yen carry trade, which is going to be very interesting.”
I assume you mean “depreciates” (you have said “appreciates” before, but I assumed it was a mistake)?
I suppose yen depreciation is possible, given the amount of base money that the BoJ have created and the size of the public debt, but I would have thought it unlikely against the dollar. In fact, as I have said before, if China can overcome its excessive nationalism (which is, incidentally, what worries me far more about China than the economic issues that are properly discussed here), switching reserves from dollars to yen would be one way in which China might preserve value.
“If they were so worried about discontent they could have spent some of that wad on their own citizens.”
US Dollars from export cannot be spent internally China. Export US Dollar revenue can only be spent for products in the US Economy or recycled in US Treasury bonds. Where the US Economy does have a comparative advantage is in high tech products, but those are highly restricted by US national security regulations from export. For instance, advanced semiconductor manufacturing equipment is banned for export to China by US government regulations. Chinese chip manufacturers must acquire chip equipment from Europe and Japan which don’t have equilvalent export restrictions.
Hi all,
Krugman’s point seems rather opaque to me: he seems to force the argument that US will go into recession because of a Dollar plunge. Personally, I can’t see why the long term interest rates should go up now (as he says) as a consequence of future higher rates expectations.
It seems more reasonable to me the point made by the people at Morgan Stanley, basically: Dollar overshooting in the short run and its resurgence further on. This point fits with Roubini and Setser point, with OBstfeld-Rogoff and with the Wile E. Coyote argument as well (i.e. short run overshooting of the Dollar).
Regarding US imports: can we be sure that they will fall? After all foreign countries can still mark to market and decrese prices further.
All this suggest perhaps one possible scenario:
1) Dollar goes down (further, due to expectation of lower rates).
2) China and other coyotes around the world sell Dollars.
3) The Dollar eventually bottoms out, but the US CA does not rebalance yet (because foreign countries price to market).
4.i) US CA deficit financing requires higher rates (as a consequence of a very high US foreing debt)
4.ii) because the Dollar has bottomed out, people expect it to go up again (as they see it as a bargain).
4.i + 4.ii) the Dollar goes up.
Best
Bernardo
…plus, I wanted to cite Surowiecki’s last article. You may probably have already read it. I find it brilliant,. It says nothing new, (it’s basically Wolf’s point vastyly discussed on this blog) but it really boils down the facts.
http://www.newyorker.com/talk/financial/2007/11/26/071126ta_talk_surowiecki
” China compaining about another currency being devalued too much. How ironic. ”
Good point.
Twofish: “Big investment banks have huge problems dealing with 15% shifts in currency values, and there is another 1000 node supercluster which does simulations to make sure that none of the banks positions will kill it in case of a large shift. Chinese banks which are only starting to get this technology would be dead in the water with a 15% maxi-reval.”
Your 1000 CPU cluster may be more productive looking for the corner in a circular room. If you insist on gambling on borrowed money not even a million CPU cluster will make the risk go away.
But why worry when you can instead go whine to Bernanke for rate cuts instead when your currency bets go bad. Then you can use charts from your 1000 CPU supercomputer to show the world how it was never supposed to happen, how it is a 25-sigma event, how it is not your fault.
china could have run larger fiscal deficits (financing domestic investment/ social safety nets), reducing national savings and thus the pace of reserve growth — but absent currency appreciation, this would be inflationary. it all goes together.
2fish — I am not with you when you talk of how the banks cannot manage a 15% reval. Until recently they had a matched book (and now they are holding fx assets v rmb deposits only b/c the government won’t let them sell the fx) so their balance sheet is protected against currency moves. They only have to worry about the indirect effects — i.e. would an exporter be less able to pay. There is no need for to run the cpus and do fancy calculations. there simply isn’t much direct exposure to currency moves. what may kill the banks by contrast is all the gov. paper (increasingly below market paper, notably the CIC bonds) that they are/ will be forced to hold to defend the exchange rate.
as for the political types, i would suggest that some of their lack of concern may stem from an information lag — a lot of political types think:
a) China doesn’t run much of a global trade surplus, just a surplus with the US (wrong — current account is now 12% of GDP, and China’s surplus with europe is now comparable to its surplus with the US)
b) China just does final assembly (partially true, but only partially, and this is changing rapidly — China’s deficit with non-oil asia (ex japan) is about to disappear as domestic parts production replaces imported parts, and in machinery/ autos/ aircraft china produces the parts rather than doing the final assembly. the key change over the past three years is that fast export growth hasn’t been matched by fast import growth as more components are made domestically.
c) Chinese reserve growth isn’t quite as fast as it now is — folks still have $200b in their mind, not the much faster pace of 07 …
I do though think there may be something to your point that the tone of the discussion changed because something was decided at the party congress. either that or something was discussed at the margins of the conference.
As for widespread understanding of the losses, you may be right that a memo was sent to the chinese leadership in early 2003, before the dollar really started to move, saying — the euro could rise 40% or more v the $, reducing the euro value of our dollars, and over time the rmb could rise by 50% or more v the RMB (look at the euro), so the potential losses on our rapidly raising dollar reserves could be really big. but the gains to the export side are even bigger — carry on. Certainly the issue of currency losses in the central bank must have been discussed — though my experience is that it is a hard concept for many to understand, just b/c central banking is hard to understand (i.e. the central bank can just create money, sterilization, the meaning of negative capital for a central bank, etc).
what i do think has changed — and this is just my personal view — is that the Chinese leadership is much more worried about the public fallout from large currency losses at the central bank.
nice article brad
I disagree with Surowiecki on one point: he argues that the rise of states as investors is a “problem of our — meaning the United States — own making.” That is partially true — fiscal deficits, the absence an energy policy. But to the extent other countries have been holding their currencies down and the dollar up and adopting policies that increase national savings (not distributing SOE dividends/ tightening fiscal policy in china/ building up oil funds with fiscal surpluses in the oil exporters) part of the problem is made globally. If some countries save more than they invest, others have to save less — that is what global equilibrium requires.
the flip side of course is that China’s exposure to the dollar is a problem largely of its own making, but also not entirely — at least not to the extent that china’s surplus stems in part from the impact of expansionary policies in the us. tho it is hard for me to see how US or European policy explains the rise in china’s surplus with europe …
Well China would be smart to start a crash program to develop its internal market for goods, would it not? It may not be able to use the $ it earns from exports to finance internal development, but if it could direct more of its production to its own internal market the export surplus would decline. The US grew rapidly early in the 20th century from its internal market, not from exports (correct me if I am wrong on this point) and never had, as a result, a “Chinese” problem.
The entire idea that some countries save more than they invest, others have to save less is absurd. The entire world runs on a fiat monetary system with US Dollar hegemony as the global reserve currency core. There is no incentive to save with a “crackpot” Federal Reserve Banking cartel that prints unlimited, debased US currency.
Helicopter Bernanke injections of newly printed monetary ‘crack’:
$15.25 billion Tuesday 11/20
$10.75 billion Monday 11/19
$ 5.25 billion Friday 11/16
$47.25 billion Thursday 11/15
$12.50 billion Wednesday 11/14
$11.25 billion Tuesday 11/13
—–
That is $102.25 billion of high-powered liquidity in “ONE WEEK”. Estimated broad M-3 money supply has exploded at an 18 percent annualized rate.
“Well China would be smart to start a crash program to develop its internal market for goods, would it not?”
The Chinese are trying hard, but it still takes time with a 1.2 billion population.
“There is no incentive to save with a “crackpot” Federal Reserve Banking cartel that prints unlimited, debased US currency.”
I guess that’s why inflation is out of control at 3%.
Guest,
Spot oil at $98 per barrel. US Dollar plunging to record low versus the Euro. Gasoline at over $3 per gallon, and a loaf of bread at $4. But we are all suppose to believe US government statistics that “core” inflation is under control at under 3 percent. Worried about the US Economy; well don’t worry about it because Bernanke says that there is no such a thing as inflation.
The only “real” inflation statistic is the one at the gasoline station sign post.
Oil makes fresh run at $100
Crude sets new closing high, rising over $3 a barrel, on refinery outages, falling dollar and Fed hints at further rate cuts.
http://money.cnn.com/2007/11/20/markets/oil.ap/index.htm
Brad wrote:
“(Wen) could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China’s dollar portfolio.
But doing so would truly cause the dollar’s value to tumble. It would dramatically reduce the value of China’s existing dollar holdings. As importantly, it would — absent a change in China’s currency policy — also push the RMB down and push up Chinese inflation.”
Actually, to “stop adding to China’s dollar portfolio” implies “a change in China’s currency policy”, whereby the PBoC will stop printing RMB to buy dollars and thus keep the RMB from appreciating. That will push the RMB *UP* and Chinese inflation *DOWN*.
” No one has made a bigger bet on the dollar that China’s government.”
suppose it is an investment, not a bet ? if saddam hussein can turn the market for the depreciating euro, china can stick to her guns and buy more dollars while they are cheap, and do likewise for the dollar. who wants to sell at the bottom ?
and it may not be the strong who dictate events, but the most fragile. if saudi arabia was signalling the danger of an o p e c break up last week – close attention would need to be paid to that.
and the chinese stock market must become fragile at some point. what effect a rush for the exits, there ? -
and the euro gets stronger and stronger – but does it ? like o p e c the eurozone can break up under stress.
the dollar sell-off and the oil buy-in are going to overshoot – at some point. the euro faces a psychological shock at $150. oil faces a psychological shock at $100. enemies threaten. friends hint.
something will break. but no one can easily predict the all important order in which things break . . .
.
Brad,
Have you done a back of the envelope calculation of the effect of dollar depreciation on the US NIIP?
It must be significant.
Maybe it will ‘pay for’ this years’s current account deficit?
“On the other hand, the dollar has already fallen rather substantially against most European currencies. The US/ European trade balance is already falling — and that is more from a dollar at 1.30 to 1.35 late last year than the dollar’s current weakness. At some point investors who are holding lots of euros or pounds might decide that the dollar is cheap. And for that matter, some investors who are already dollar heavy might decide that at this stake, they should double down. China should have bought more euros back in mid 2004 — or much of 2005 — at around 1.20. But 1.45 (now almost 1.48) isn’t 1.20. Maybe the right strategy for China and other big holders of dollars now is to sell euros and buy dollars to raise the dollar share of its portfolio in the hope that the dollar will rally v the euro …”
maybe its better to diversify further more and to buy BRIC and EM currencies instead of overpriced euro and pound? if they break the dollar peg they will revaluate.
50 Cent: If you insist on gambling on borrowed money not even a million CPU cluster will make the risk go away.
Banks make their money by borrowing money from one group of people and lending it to another group of people. If you’ve done everything correctly, then any losses or gains that you making from borrowing get canceled out by losses or gains that you making lending.
50 Cent: But why worry when you can instead go whine to Bernanke for rate cuts instead when your currency bets go bad.
Because rate cuts are a band-aid that fix liquidity issues, but don’t work to stem large scale bleeding. Also, in exchange for getting help from the Fed in case of a crisis, you have people from the Fed monitoring the bank for risk exposure.
50 Cent: Then you can use charts from your 1000 CPU supercomputer to show the world how it was never supposed to happen, how it is a 25-sigma event, how it is not your fault.
Things don’t work that way in banks. “The computer said that this was impossible” is not an excuse. If the computer says that it is impossible and it happens then the guys who programmed the models that said it was impossible are going to having their rear ends tacked against the wall.
You can play Wile E. Coyote for short periods of time, but ultimately gravity wins.
bsetser: I am not with you when you talk of how the banks cannot manage a 15% reval. Until recently they had a matched book (and now they are holding fx assets v rmb deposits only b/c the government won’t let them sell the fx) so their balance sheet is protected against currency moves
The large scale balance sheet is protected against currency moves, but there are all sorts of small scale operational issues that can expose a bank to currency moves. Suppose a bank exchanges RMB to dollars with the intention of switching it back to RMB at some future date. If the exchange rate is fixed, then there is no need to do the switch back immediately. Once the currency starts moving, then you want to change the procedures to do the switch immediately so as not to be exposed to currency risk.
That changes a lot of other operational procedures. For example, it may not have been a bad thing to get someone’s rubber stamp before releasing money when you could hold it for a week, but now that you need to do the switch now, it’s not a good idea to get this person’s signature, because that person could be on vacation.
Sometimes these are really stupid things (like going through all the thousands of Excel spreadsheets that people use to make sure that you can change the RMB/USD exchange rate).
Think Y2K. It was total chaos in Chinese banks for a while after the 2005 reval.
Also most PRC banks have subsidiaries in Hong Kong which gives them some currency risk. Going through and checking the level of currency risk is non trivial. One of the things that I think the pseudo-peg was intended to do was to point out areas that banks had currency risk. I’m pretty sure that there have been some “oh my god, I didn’t think that this would be a problem moments” since the currency had been unpegged.
That’s at the banking level. Any manufacturer will have to go through the same process.
One prediction. If there is a max-reval, it will happen on a Friday. That way everyone will have the weekend to figure out what the implications are.
“…The weakness of the southern constituent countries of the euro is less efficiently discounted. The cri de coeur of French President Nicolas Sarkozy over dollar weakness in the dollar’s home tells us that the ability of the European Central Bank board to maintain a consensus, in public at least, is at risk. The problem is that the economic vulnerability to what could be called the “Latin bloc” is more immediate than the inflation threat to the “German bloc”… The key event is the Spanish election in early March. After that is out of the way, it will be much easier for whatever Spanish government is in power to admit the country’s economy is in a bad way…” http://www.nakedcapitalism.com/2007/11/blue-chip-art-auctions-show-rich-as.html
“all the ingredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood”
I guess Mr. Creosote shouldn’t have eaten that wafer-thin mint after all.
Bilmon — funny that you show up the moment i make a slightly alarmist post … nice to hear from you.
Unokai — my understanding is that most central banks still lack the authority to hold reserves denominated in emerging market currencies. they would need formal authorization — i.e. a political decision. and since all the bRICs now either have a current account surplus or are attracting more inflows than they want (india), any central bank buying a bric currency just adds to bric reserve growth. that said, it does make sense (see the last item in my little essay).
gillies — your eurozone breaks under the pressure of euro strength scenario isn’t at all implausible. and I can see the logic for china to double down and sell all its euros for dollars (taking profits on the euros) and, well, trying to change psychology around the euro/ $. But, well, that would be one hell of a risk — and something that would have to be approved at the top. If China bought a ton of dollars (letting all central bnaks with more $ than they want basically sell to the PBoC) and the dollar then tanked, watch out (politically). right now those who supported the dollar are on the defensive — so i doubt this will happen. it might happen on the private side — but there you run into the falling rates/ us economic weakness/ etc.
Twofish: “Things don’t work that way in banks. “The computer said that this was impossible” is not an excuse.”
It worked for LTCM. Of course a bank is regulated and cannot act like a hedge fund, right? Well not exactly. All you got to do is to setup off-balance sheet entities to do the dirty work for you.
Twofish: “If the computer says that it is impossible and it happens then the guys who programmed the models that said it was impossible are going to having their rear ends tacked against the wall.”
I am sure they are trembling with fear on the possibility that they may have to retire on last years $50M bonus.
anonymous — i haven’t done the calculations (or even compared local currency returns across equity markets recently) but i would suspect that valuation gains on the united states external assets more than offset the increase in debt associated with the current account deficit. the NIIP should improve. of course, foreigners holdings dollars took big valuation losses — and that, not the improvement in the US NIIP, seems to be driving the dollar. Some seem to be getting a bit more reluctant to buy an ever-falling currency.
Come on Brad, you can do better than this: “If some countries save more than they invest, others have to save less”. You don’t need to be an economist to spot the non-sequitur. It should say “….others have to invest more than they save”. And it was certainly within the power, if not the inclination, of the US to invest more.
Written by RebelEconomist on 2007-11-20 17:16:07
What’s your problem?
Brad’s simply states an automatic accounting identity.
And it applies to the US (they save less than they invest).
There’s no non sequitur. It’s true.
What isn’t true is the implication of your final sentence – in fact, as obvious by the accounting identity, and by the evidence of the national accounts, the US DOES invest more than it saves.
Who’s the economist again?
50 Cent: It worked for LTCM.
LTCM got closed down and the assets spread to the banks that lent it money. When you owe someone money, “the computer said that this is impossible” doesn’t quite cut it.
50 Cent: Of course a bank is regulated and cannot act like a hedge fund, right?
Something like that….. Banks do have people doing prop trading and hedge fund like things, and when times are good, these people make mega-bucks, but they are also the first people tossed out the door when times go bad. There are also lots of people in the back office keeping the prop traders on a leash, and lots of people at the Fed that are keeping the people in the back office on a leash.
50 Cent: Well not exactly. All you got to do is to setup off-balance sheet entities to do the dirty work for you.
Doesn’t work. The Federal Reserve monitors off-balance sheet entities and they are included as part of risk management. Moving something off-balance sheet doesn’t remove it from risk management because you still have to risk manage the off balance-sheet entity.
50 Cent: I am sure they are trembling with fear on the possibility that they may have to retire on last years $50M bonus.
CEO’s make $50M bonuses, most people in banks don’t. Total compensation for experienced quants at the VP level are in the $200K-$400K range. Crap rolls downhill, and I hate to be the person that miscalculates a model that gets forwarded up the chain of command to cause the CEO to lose their job.
For people at the managing director or higher level, money isn’t much of a motivator since they have more money than they will ever need, and they could stop showing up at the office tomorrow and head on a plane to the Cayman Islands. People at that level are motivated by power or glory.
Also, “fat tails” aren’t too hard to model or risk manage. If you are interested on what happens when the stock market drops 30%, you just put that in the model and you get a number. The hard part are the correlation effects. Suppose the stock market drops 30%, it’s likely that there are two hundred other “interesting” things going on. What are they and what do they do to the bank?
The real interesting part is suppose the stock market drops 30%, what happens two weeks or two months later?
DC: . But we are all suppose to believe US government statistics that “core” inflation is under control at under 3 percent.
That sounds plausible. Whatever increases there are in gas and food prices are likely to be matched by decreases in housing prices and rents. Housing prices are dropping and they probably have a long way to go.
Guest: I read your response to this and I wonder about Chinese domestic investment in health care, social security, and education.
They actually have. My crystal ball says that the next Party Congress is going to be about the New Cooperative Medical System that provides universal health care and the free education provided to everyone up to ninth grade.
The problem with putting together a health care and education system isn’t money. There’s always been enough money. The problem is figuring out whose pocket the money comes from and whose pocket does the money go to, and getting the details right. That has involved putting together pilot programs, studying the results to figure out where things worked and where they didn’t, and the working until you get everything right.
Guest: Why couldn’t the Chinese have done this, thereby in the long run cultivating a consumer class?
Because putting together a system of universal education and health care takes time and not money. Also, it really doesn’t cost that much. Paying for universal health and education is likely to add about US$20-$30 billion to the PRC budget.
I meant someone saves more than they invest and someone else saves less than they invest even if i dropped the last invest. For a while the us was saving less and investment was up — tho not relative to the .com era — on the back of residential investment. Now the US current account deficit reflects low levels of savings (even as investment is falling a bit).
q4 will be interesting — the US (consumer) will have to finance its oil bill somehow ..
“Spot oil at $98 per barrel. US Dollar plunging to record low versus the Euro. Gasoline at over $3 per gallon, and a loaf of bread at $4. But we are all suppose to believe US government statistics that “core” inflation is under control at under 3 percent.”
Dave,
1) The inflation adjusted price of oil is quite reasonable, even at $100 per barrel.
2) Records lows against the Euro don’t mean that much, considering the Euro is only 7 years old. The dollar traded at around current levels in 1980.
3) I think you better a different place to buy bread. Your grocer is overcharging you.
Twofish: “LTCM got closed down and the assets spread to the banks that lent it money. When you owe someone money, “the computer said that this is impossible” doesn’t quite cut it.”
The LTCM principals got a bailout that enabled them to walk home with several hundred millions. Sure they lost many hundred millions more but they still got bailed out and went home rich.
Twofish: “There are also lots of people in the back office keeping the prop traders on a leash, and lots of people at the Fed that are keeping the people in the back office on a leash.”
Unfortunately this is a fairy tale. Of course there is a leash but is it big enough for the dog?
Twofish: “The Federal Reserve monitors off-balance sheet entities and they are included as part of risk management.”
Someone please inform Henry Paulson. He is busy bailing out Citi’s SIVs precisely because no-one did any risk management on those entities, and Citi refuses to put them on balance sheet.
Twofish: “CEO’s make $50M bonuses, most people in banks don’t. Total compensation for experienced quants at the VP level are in the $200K-$400K range.”
Wall St took home something like $50B in bonuses last year. Some of it was based on mis-priced assets that have subsequently blown up. Sure they may lose their jobs, I don’t see anyone returning their bonuses because they turned out to be based on incorrect valuations.
As far as LTCM went, the managers kept the money that they made pre-blowup, but they didn’t get any money from the Fed loan. The LTCM investors got soaked, but they weren’t widows and orphans.
As far as SIV’s go, people did risk management, but they didn’t see the particular mode of failure that caused them to go bad. The problem is that people were focused on the value of the underlying assets, and not on the liquidity problem that you get when everyone heads for the exits at the same time. Something to keep in mind for the future. Paulson’s on the phone, but he’s not putting up any government money.
50 Cents: Wall St took home something like $50B in bonuses last year. Some of it was based on mis-priced assets that have subsequently blown up. Sure they may lose their jobs, I don’t see anyone returning their bonuses because they turned out to be based on incorrect valuations.
No, but people that worked in places that did better risk management and valuations get to keep their jobs, which is plenty of incentive to do it right. Especially since if you kept your job, you get a bonus this year. If you lost your job, you don’t.
Pardon a bit of naivete, but I’m a tad confused.
Why should the sovereign gov’t of China worry much about the purchasing power impact of changes in the RMB/USD exchange rate on their official forex reserves? They seem at risk because of their large US$ holdings to losing EUR, JPY, etc., purchasing power when the EUR/USD, JPY/USD, etc., rates shift. But if the RMB (assumedly permanently) rises against the USD, the impact on their reserves is equivalent to a bunch of RMB disappearing from the world, but they can “cure” that by just printing more. The only “loss” is of something they have sovereign power to re-create.
Obviously privately-held piles of US$ have risks. But the Chinese gov’t owns the foreign exchange reserves, and the Chinese gov’t has full control over the ability to print RMB. Yes?
What am I missing?
Brad,
Why do omit Gold as an option for CBs who think they are still overweight dollars?
Thanks,
Scott
gold doesn’t pay a coupon, I am not sure there is enough of it to go around and it isn’t something I feel like I understand.
DA — a central bank issues currency against an asset (currency is a liability to a central bank). usually that asset is foreign exchange or a domestic government bond. when people talk about “printing money” what they usually mean is printing money to finance a fiscal deficit — i.e the central bank lends money to the government (the loan is the asset) that the government spends (Adding to the money supply) or the central bank buys gov. bonds (an asset) for cash.
if a revaluation/ rmb appreciation reduces the value of the central banks assets (in fx) relative to its liabilities (domestic currency cash and sterilization bills), the result is more liabilities than assets. That need not be fatal, but it cannot be cured by just printing more cash (issuing more liabilities). in fact, issuing more liabilities without an offsetting asset adds to the problem. the central bank can either operate with negative equity (i.e. more liabilities than assets) or the government can give the central bank a bond (which pays interest). and this would need to be a gift — the central bank wouldn’t be issuing any currency in exchange. the gift would make up for the losses on the revaluation.
at least that is how i understand it.
sorry if it is a bit technical.
“all the ingredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood”
just provide a credible explanation of exactly how you see that happening, as you are claiming it is possible – who are the sellers and where they ‘reinvest’ the proceeds – and who are the buyers and what they are presumably selling in order buy the – ‘worthless’ in your view? – dollar denominated securities.
“In reality, the current Hu Jintao Chinese leadership doesn’t give its highest priority to relations with the United States.”
I think what you meant is that the leadership didn’t give its highest priority to considering the effects of a mercantalist trade policy which consisted largely of accumulating dollars.
If the leadership didn’t give its highest priority to this, then they are criminals, since they effectively sold the Chinese worker as slaves to the American consumer so that their version of the investment banker (the owners of factories and such) could get rich. With luck the Chinese leadership will all get shot for their neglect.
The Chinese dollar reserves will not loose their value more than the US consumers loose their purchasing power, if the Chinese will spend them on goods and services produced in the US (or goods that are priced in USD). Maybe they think that their children and grandchildren will have a good time buying things from the US with the trillions of dollars they pile up now. Maybe the US should be more worried than China, that for decades to come there will be an outside buyer with lots of money who wants to buy the same food or other things as its own citizens.
“That sounds plausible. Whatever increases there are in gas and food prices are likely to be matched by decreases in housing prices and rents. Housing prices are dropping and they probably have a long way to go.” – Twofish
Not plausible. When housing prices were rising, the Fed switched to equilvalent rents. Rents weren’t significantly rising due to so many new houses purchased by former renters. Now that housing prices are falling, how convenient it is for the Fed to switch the CPI back to falling home prices. The Fed also masks “real” inflation using hedonic distortions and substitutions. An doubling of your computer’s processing speed doesn’t double your productivity, but that is the way the Fed measures it. And price substitutions are a bogus method to count inflation. The US government thinks that if steak prices rise too fast, people will substitute hamburgers or chicken, thus lowering the CPI index. Well why not take it one absurd step further: eliminate hamburgers and chicken meat from the CPI and substitute cheaper dog food. No one believes the Fed anymore, that is why Gold and Oil prices are soaring, the US Dollar is plunging versus the Euro and yen. With a loss of total credibility, the Fed is seen to have no clothes.
The AAA level of the ABX indices fell to another new all-time low of 72. More mortgage credit market destruction.
http://www.markit.com/information/products/abx.html
And the US Dollar index plunged to a new all-time low of 75.
But these things don’t matter anyway.
The stock market is doing okay and that is what the American people really consider to be important. What a giant charade.
wonder which one happens first…
oil $100/barrel
or
1 euro=1.50 usd
Goldman Sachs political control of US Government policy
http://www.nytimes.com/2007/11/19/business/19goldman.html?pagewanted=2&ei=5087&em&en=add16081735ef741&ex=1195794000
In the race for president, Goldman Sachs executives are the top contributors to Barack Obama and Mitt Romney, and the second highest contributor to Hillary Rodham Clinton. Mr. Blankfein has held a fund-raiser for Mrs. Clinton in his apartment and has come out publicly in her favor.
Another member of Goldman’s influential diaspora is Philip D. Murphy, a retired executive who is the chief fund-raiser for the Democratic National Committee.
Goldman Sachs is included in President Bush’s working group on the markets, an informal committee led by Mr. Paulson that includes Ben S. Bernanke, the chairman of the Federal Reserve; Christopher Cox, the chairman of the Securities and Exchange Commission; and Walter Lukken, the acting chairman of the Commodity Futures Trading Commission.
I take it that this:
q4 will be interesting — the US (consumer) will have to finance its oil bill somehow
means that China is no longer financing that oil bill…sending somewhat larger tbill auctions back for more attractive pricing for the remaining private foreign investors?
Hard to believe that China won’t continue with it’s trade of a thundering export sector for lousy investment returns on vast quantities of US tbills. Unless consumption for those exports falls regardless of those tbill purchases…a scenario that looks more and more likely as new homeowners “regroup” hoping Arnold’s gesture is the first of many.
Anonymous on 2007-11-20 18:02:05:
Having read Brad’s reply, you will hopefully understand what I was getting at.
This is not just a pedantic point. My concern is that people read what experts like Brad say, and base their opinions on it. If Brad says that consumption somewhere must rise if China produces more than it invests, some Americans think they are doing the world a favour by consuming, and call for someone to take over when they start to flag. In a world of increasing scarce resources, including the carbon dioxide carrying capacity of the atmosphere, and an ageing population in developed countries, I fear that this view is deluded.
Chinese forex losses may be partially offset by capital gains.
With long-term treasury bond rates falling, the Chinese may be benefiting from the market panic they helped create. As panicked investors scramble for the “life boats”, the Chinese can sell into strength.
This, in my opinion, is ironic.
“Gold reserves are held by central banks as a store of value. At the end of 2004 central banks and official organizations held 19% of all above ground gold as a reserve asset… Three quarters of the gold reserve was contributed by G5 members, namely France, Germany, Japan, United States and United Kingdom…” http://en.wikipedia.org/wiki/Official_gold_reserves
Of course I should have said “China saves more than it invests” in the above comment!
One of Brad’s reasons for dismissing gold as an alternative to dollars in reserves is that “it pays no coupon”. This also looks patronising coming from a country which now holds over three quarters of its reserves in gold.
Written by RebelEconomist on 2007-11-21 09:39:21
Sorry, I didn’t read anything into Brad’s response other than a confirmation of my point.
But your final point taken separately is certainly a legitimate point. The accounting identity shouldn’t suggest a moral or economic obligation to consume the output of current account surplus countries.
On your other point, the problem of excess US consumption doesn’t relate only to how much the US invests domestically, since demand distribution is complicated by the existence of a huge current account deficit. Given this, it relates more directly to how much the US saves. If you see a problem regarding the quantity and/or quality of US investment, I think you have to focus on the consumption/investment mix of output generated by US GDP. If you have a problem with US consumption, then I think you have to focus on how much the US saves, particularly in the context of the very large current account deficit.
Conversely, Brad’s confirmation of the accounting identity (however one interprets it behaviorally) has nothing directly to do with how much the US invests. The current account deficit could exist in theory with 0 investment or with investment equal to GDP.
I’m pretty sure I see the point you’re making about US excess consumption and US deficient investment (in some sense), but I think you have to be careful in connecting the dots as it relates to a current account deficit in an open economy and the corresponding positions of the surplus economies.
“…the FRBNY’s stocks are larger even than Fort Knox… The gold is owned by many foreign nations, central banks and international organizations. The Federal Reserve Bank does not own the gold but serves as guardian of the precious metal, which it “protects” at no charge as a gesture of good will to other nations…” http://en.wikipedia.org/wiki/Federal_Reserve_Bank_of_New_York
“…The closest we got to a dollar-gold link was in September 1987, when then-Treasury Secretary James Baker III proposed an international monetary reform that would link the major currencies together, with central banks using “a commodity basket, including gold” as a “reference point,”…” http://www.wanniski.com/showarticle.asp?articleid=3064
Anonymous on 2007-11-21 10:23:12
Maybe I am confusing things by using “investment” in a non-standard way. I would consider imports of capital goods as investment, and so am thinking that the US could invest more without a change in the makeup of US GDP. For example, the US could have imported wind turbines from, say Germany, instead of toys from China.
I think that a problem for the US is that some of these adjustments are most easily accomplished by the state (eg by carbon tax spent by a public power utility), and the US has a bias towards a small state. The trouble is, that the challenge from China, India etc may well be so big that America needs some kind of collective effort of a kind not seen since the second world war.
Rebel – the United States large gold reserves are more of a historical legacy of the gold-dollar BW1 system than a conscious choice. I take your point that a bit more energy conservation in the us would help, tho i would note that by reducing the market price of oil, it would also cut into savings in the oil exporters.
Brian — as far as I know, China doesn’t market its bond position to market so it doesn’t show the capital gain on its balance sheet (Japan does, and the gain should be very visible in November). Moreover, in a context where China is adding to its reserves not reducing them it cannot in aggregate really realize any gains. it can book a gain by selling its old bonds, but it then has to reinvest the gains in new bonds with a lower coupon. it could sell its older bonds at a gain and hold short-term instruments, but (and indeed it seems to be doing that to a degree) there are limits to how much short-term stuff it wants to have to roll over. the easier trade is to sell treasuries and buying something that now trades at a large spread v treasuries, but to do that, you need to be confident that you understand credit risk in the US …
DC: Not plausible. When housing prices were rising, the Fed switched to equilvalent rents. Rents weren’t significantly rising due to so many new houses purchased by former renters. Now that housing prices are falling, how convenient it is for the Fed to switch the CPI back to falling home prices.
Mortgage prices have always been part of CPI. Also CPI isn’t calculated by the Fed, but rather by the Bureau of Labor Statistics. In any case, falling home prices should be part of CPI, and drops in home prices seem to be canceling out any price rises in commodities.
It’s important in looking at statistics to ask yourself “do these statistics make sense based on what I’m seeing on the street” and I don’t see any general inflation in the US since price rises in one thing seem to be counteracted by drops in another.
Stay Away from Robert Rubin’s Citicorp,
http://www.counterpunch.org/martens11062007.html
Citigroup has been repeatedly charged in investor lawsuits with creating off balance sheet structures to hide the debt of large U.S. firms such as Enron. In each case, it has been allowed to pay millions to regulatory bodies and billions to private plaintiffs to settle the charges without an admission of guilt and avoid a public trial. These trials, however, might have provided critical transparency and an early warning to the public and its colleagues on Wall Street.
But next year, Citigroup will face trials in both Italy and the U.S. in two separate actions for creating off balance sheet structures that plaintiffs contend were significant contributors to the bankruptcy of the giant Italian milk company, Parmalat. Citigroup named one of these structures Buconero, Italian for “black hole.” Another structure Citigroup set up for Parmalat sold commercial paper, backed by fake invoices, to U.S. money market funds. Citigroup contends it was “the victim” in all matters related to Parmalat.
The U.S. trial, set for May of 2008 in a New Jersey State Court, is not being brought by a U.S. prosecutor, but an Italian trustee for Parmalat, Enrico Bondi.
Dave Serchuk, a reporter for Securities Week at the time, reported in its February 2, 2004 issue that Citigroup had bundled essentially worthless Parmalat debt and sold it in the form of asset backed commercial paper to what U.S. investors thought were among the safest and most liquid investments: money market funds. Unfortunately, the incendiary Parmalat/Citigroup money market story failed to get picked up by U.S. mainstream media.
Now, once again, one of the most troubling aspects of the current Citigroup debacle that has gone unreported is the extent to which these opaque and convoluted debt instruments managed by Citigroup, called CDOs (collateralized debt obligations), got dumped into Cayman Islands SIVs, transmuted into AAA-rated commercial paper, landed in the so-called safe money market funds in the U.S., including an astonishing amount at Citigroup’s competitor, Merrill Lynch.
According to Standard & Poor’s Structured Finance research reports, Citigroup is managing the following Structured Investment Vehicles (SIVs), incorporated in the Cayman Islands and not consolidated on Citigroup’s balance sheet: Centauri Corp., Beta Finance Corp., Sedna Finance Corp., Five Finance Corp., and Dorada Corp. (1) In addition, according to press reports, Citigroup created two more SIVs as recently as November 2006: Zela Finance Corp. and Vetra Finance Corp. (2) These SIVs contain approximately $80 Billion in what is increasingly being viewed as toxic debt.
Twofish,
It is disingenous for the Fed and the US government to promote the phony “core rate” of inflation that excludes energy, food, and commodity prices. Yesterday, Bernanke with a straight face stated in Congressional testimony to Ron Paul that “there was absolutely no inflation”. In reality, food and energy prices are the core expenditures for the majority of American families.
Real annual inflation was around 10% before the credit crisis. Now the Bernanke Fed will need to inflate like crazy in a desperate attempt to support the collapsing credit markets. The shadow government folks use the pre-clinton era statistics to calculate reconstructed Consumer Price Index (CPI).
http://www.shadowstats.com/cgi-bin/sgs/data
Note: The CPI chart on the home page reflects our estimate of inflation for today as if it were calculated the same way it was in 1990. The CPI on the Alternate Data Series tab here, reflects the CPI as if it were calculated using the methodologies in place in 1980.
P.S. Mortgage Prices were removed from the CPI and replaced with “equilvalent rents”. The statistical change significantly lowered the CPI index during the past Housing bubble.
Brad,
Now you are making really lame excuses for US policy! When did gold-based BWI end? 1971! The US could have easily sold all its gold by now. We in the UK sold about half of ours for assets with a coupon…….and have regretted it ever since! Many other countries have sold significant amounts of gold. The US Treasury preaches to developing countries about the poor returns from reserves invested in US treasuries while holding most of its own reserves in assets returning zip. Is it any wonder that the rest of the world are tired of being lectured by the US?
Written by RebelEconomist on 2007-11-21 11:16:17
Point taken. If the import composition shifts from consumer goods to investment goods, the ‘quality’ of the current account deficit ‘improves’ in that sense. It should also be more attractive for offsetting capital inflows in the sense that a broadening investment base strengthens the country’s ability to service external debt.
But the country still saves less than it invests. It is foreign saving that is funding domestic investment at the margin – not domestic saving.
“…The bank chosen for the custodian assignment would oversee the financial record-keeping and other back-office operations for the new fund. It would be a prominent and potentially lucrative task for Bank of New York Mellon, which has largely shunned the spotlight despite its legacy as America’s oldest bank, founded 223 years ago by Alexander Hamilton…” http://www.nytimes.com/2007/11/21/business/21siv.html?dlbk
“Bank of New York Mellon has agreed to a joint venture with a Chinese an asset management firm, as the US fund manager and custodian expands in emerging markets for growth. BNY Mellon Western Fund Management will start managing domestic Chinese securities, but is expected to develop additional products…” http://www.financialnews-us.com/index.cfm?page=ushome&contentid=2349235251
http://www.globalcustody.net/ca/custody_assets_worldwide/
Anonymous on 2007-11-21 12:18:02:
Right! My argument is that the US should have responded more constructively to the role thrust upon it as the world’s banker – and quite possibly made a turn (”exorbitant privilege”) on it – by wise investment (in my sense) both in its own productive capacity and (my other hobby horse) in building its own reserves. Investing in wind turbines might have freed resources to care for the elderly in future years. The US is still a rich, highly productive nation, so all is not lost, but the sacrifice required now is greater.
By the way, thanks for the discussion.
Has anyone considered that there may be a reason the US has kept a considerable amount of its reserves in Gold (while simulataneously encouraging other CBs to sell their Gold and hold increasingly worthless paper promises from the US).
Maybe I am giving TPTB too much credit here.
Twofish: “As far as SIV’s go, people did risk management, but they didn’t see the particular mode of failure that caused them to go bad. The problem is that people were focused on the value of the underlying assets, and not on the liquidity problem that you get when everyone heads for the exits at the same time.”
What a sorry excuse. Everyone ALWAYS heads for the exits at the same time. Thats how markets work. Any “risk manager” who pretends to be surprised by this phenomenon is insincere and dishonest. This is the Wall St equivalent of “the dog ate my homework”.
Twofish: “Something to keep in mind for the future.”
Yeah thats what they said when LTCM blew up because of the exact same problem of illiquidity. Wall St will continue to ignore or undervalue liquidity because that will allow them to artificially inflate asset values and earn big bonuses.
Twofish: “Paulson’s on the phone, but he’s not putting up any government money.”
His participation as Treasury secretary in creating the SIV is worth billions of dollars in added credibility. Billions that Citi is getting for free. And billions that the taxpayer pays for in terms of increased moral hazard.
rebel. the us kept a lot of reserves in gold b/c the gold bugs were dead set against any sales; in the 1990s, there were constant accusations that covert us gold sales were holding the price of gold down. the treasury got a surprisingly large number of letters on this topic …
strong, vocal constituency against. limited constituency for. no need for the money. etc. wasn’t a priority.
“…Rational gold miners who do not subscribe to conspiracy theories, say they do see evidence that unseen forces are depressing the gold price every time it pops…” http://news.bbc.co.uk/2/hi/business/665315.stm
China showing its irritation at the US?
HONG KONG (Reuters) – China has refused permission for a U.S. aircraft carrier and accompanying vessels to visit Hong Kong for a long-planned Thanksgiving holiday visit, the U.S. State Department said on Wednesday.
Thousands of US relatives of the crew had flown to HK for the visit. Too bad for them. LOL.
50 Cents: What a sorry excuse. Everyone ALWAYS heads for the exits at the same time. Thats how markets work. Any “risk manager” who pretends to be surprised by this phenomenon is insincere and dishonest. This is the Wall St equivalent of “the dog ate my homework”.
Everyone always heads to the exits at the same time, but it’s always tough to figure out which exit they will head to. In the case of SIV’s, what happen was that people were dumping asset backed commercial paper to raise cash to handle redemptions. You can imagine things happening slightly differently and having a flight to quality in which people start buying up large amounts of asset backed commercial paper, in which case the risk structure that would save your rear end in one situation would kill it in another.
The solution to this is to not even try to figure out exactly how the system fails, but to make sure that you have enough capital to withstand general failures.
There are tens of thousands of financial instruments being traded. In summer-2006, it would have been very difficult to say “SIV’s will blow up in response to subprime mortgages.” Let me give you a menu of all of the financial instruments now being traded, and I don’t think that you or I will be able to guess which one will be the next one to blow up, especially since the one we pick will have attention focused on it, and not blow up.
50 Cents: Yeah thats what they said when LTCM blew up because of the exact same problem of illiquidity.
LTCM didn’t blow up because of illiquidity. Once it blew-up, then you had a liquidity crisis, but there weren’t any liquidity problems that led to the blowup. The initial blow up was due to over-leveraging and much of the solution was to have the IB’s tighten up their lending to hedge funds.
50 Cent: Wall St will continue to ignore or undervalue liquidity because that will allow them to artificially inflate asset values and earn big bonuses.
Can you explain how this works? Because you can sell short, inflated asset values don’t always lead to big bonuses, and if your book is short, you want asset values to go as low as you can. That’s how Goldman made a bunch of money from sub-prime.
There is a difference between asset values and liquidity. In a liquidity crisis, no one is buying or selling at any price.
50 Cent: His participation as Treasury secretary in creating the SIV is worth billions of dollars in added credibility. Billions that Citi is getting for free. And billions that the taxpayer pays for in terms of increased moral hazard.
The thing about it is that it’s not clear that the super-SIV is going to work. People are still skittish about SIV’s and these sorts of structures. Also, while people differ on this, I don’t really accept the moral hazard argument. If the moral hazard argument were the case, then people would be betting on the exact same thing over and over, and people don’t. The asset that causes problems in the next situation is always different than the one that caused the last situation. It’s always the same…. and always different….
For example, in this situation, you *didn’t* have a LTCM-like meltdown. There were only a few hedge funds that failed, and their failure didn’t cause anything like the turmoil that LTCM did. Part of the reason is that people have been spending the last few years monitoring systemic risk in hedge funds and that paid off this time.
DC: In reality, food and energy prices are the core expenditures for the majority of American families.
They aren’t.
http://www.bls.gov/cex/csxann05.pdf
Again, this is a situation in which you stop looking at the numbers for a while and go talk to people. With enough effort you can make any number say anything you want, so it works to just go out and take a walk to see if the numbers make any sense.
The BLS numbers roughly match my personal experiences. Now it could be that I’m particularly inflation proof, but I just don’t get the sense talking to people that inflation is that big of a concern in the United States.
Twofish: “There are tens of thousands of financial instruments being traded. In summer-2006, it would have been very difficult to say “SIV’s will blow up in response to subprime mortgages.”"
Sorry but that is utterly predictable. People have been warning about the housing bubble for years now and if the assets behind your ABCP’s are MBSes of course they were going to lose value.
You can keep denying it all you want but even Jamie Dimon has now admitted that the SIVs have no economic purpose and will have to be shut down. Talk about closing the barn door too late..
Twofish: “The solution to this is to not even try to figure out exactly how the system fails, but to make sure that you have enough capital to withstand general failures.”
Well, Duh! The question is why didn’t they? The answer is greed and willful denial.
Twofish: “Let me give you a menu of all of the financial instruments now being traded, and I don’t think that you or I will be able to guess which one will be the next one to blow up, especially since the one we pick will have attention focused on it, and not blow up.”
The diversity in financial instruments is a mere illusion. A very large number of them were based on mortgages, others on LBO-debt. To any honest observer it was always clear that all of these securities were driven by cheap money and they were all going to be affected when it dried up.
Twofish: “LTCM didn’t blow up because of illiquidity. Once it blew-up, then you had a liquidity crisis, but there weren’t any liquidity problems that led to the blowup. The initial blow up was due to over-leveraging and much of the solution was to have the IB’s tighten up their lending to hedge funds.”
I don’t know how you can claim that LTCM did not blow up because of illiquidity. Of course they did. LTCM’s assets were high quality but they could not liquidate them to meet margin calls. That is the very definition of illiquidity.
Twofish: “Can you explain how this works? Because you can sell short, inflated asset values don’t always lead to big bonuses, and if your book is short, you want asset values to go as low as you can.”
Thats easy: you inflate the value of your long positions and deflate the value of your short positions. The idea is to inflate the value of *your* assets. When you use mark-to-model accounting there is no reason why you have to be consistent. Theoretically you can make “money” trading with yourself. And take a bonus for it.
Twofish: “That’s how Goldman made a bunch of money from sub-prime.”
It is a mystery how Goldman made money on sub-prime. Maybe they didn’t and are merely playing a dangerous game of brazening it out. Who knows what skeletons they are hiding under their “Level 3″ accounting.
Twofish: “There is a difference between asset values and liquidity. In a liquidity crisis, no one is buying or selling at any price.”
Thats an exaggeration. In a liquidity crisis there are FEWER buyers and they demand bigger premiums. Why this is surprising to anyone is not clear to me.
Twofish: “The thing about it is that it’s not clear that the super-SIV is going to work. People are still skittish about SIV’s and these sorts of structures.”
They are skittish with good reason. The SIVs are a scam, a shell game. How does this change anything about the appropriateness of Paulson’s actions?
Twofish: “Also, while people differ on this, I don’t really accept the moral hazard argument. If the moral hazard argument were the case, then people would be betting on the exact same thing over and over, and people don’t.”
Thats a very self-serving argument for Wall St don’t you think? If the casino gives you chips to play on the house will that increase or decrease the size of your bets? Of course moral hazard is a problem. It is just difficult to quantify exactly what it costs.
And apart from the economic costs there is also the basic issue of fairness. Why isn’t the government bailing out *everyone* who has financial difficulties?
Twofish: “For example, in this situation, you *didn’t* have a LTCM-like meltdown. There were only a few hedge funds that failed, and their failure didn’t cause anything like the turmoil that LTCM did. Part of the reason is that people have been spending the last few years monitoring systemic risk in hedge funds and that paid off this time.”
It is too soon to tell. We will see.
50 Cent: Sorry but that is utterly predictable. People have been warning about the housing bubble for years now and if the assets behind your ABCP’s are MBSes of course they were going to lose value.
Trouble here is that ABCP’s *aren’t* backed by housing assets. ABCP’s have nothing to do with subprime mortgages other than the fact that you had the same investors in both. Also, prime MBS’s haven’t lost value. Prime MBS’s aren’t sensitive to housing prices, since they are lent based on the credit of borrower and there is enough capital reserve so that changes in housing prices don’t affect the security. A prime MBS can only be lent for 80% of the house value, which means that home prices have to drop a lot more before they get hit.
(Regarding capital reserves).
50 Cent: Well, Duh! The question is why didn’t they? The answer is greed and willful denial.
IB’s *did* have enough capital reserve to deal with this mess. No bank is coming close to failing.
50 Cent: Of course they did. LTCM’s assets were high quality but they could not liquidate them to meet margin calls. That is the very definition of illiquidity.
Why did they have to meet a margin call? Because they were overleveraged, and once you are bleeding everyone out there is going to try to take a piece of you. But ultimately LTCM didn’t have much to do with liquidity, because even if it had been able to liquidate everything, then it still would not have enough to stay afloat.
50 Cent: Thats easy: you inflate the value of your long positions and deflate the value of your short positions. The idea is to inflate the value of *your* assets. When you use mark-to-model accounting there is no reason why you have to be consistent.
Yes you do, because you have to post a valuation to your counterparty, and if the valuation is good for you, it’s bad for them, and they’ll start screaming. This stops working if you control your counterparties, which is what Enron did, but banks don’t control their counterparties, which means that banks (fortunately) can’t use accounting tricks to get out of their messes.
Suppose you get a letter from the bank saying that because they are running into some problems, they want to value the derivative contract that they are holding with you at some high value, which means you owe them more money.
50 Cent: Theoretically you can make “money” trading with yourself. And take a bonus for it.
No you can’t, at least for very long. Enron tried that. It didn’t work too well.
50 Cent: It is a mystery how Goldman made money on sub-prime. Maybe they didn’t and are merely playing a dangerous game of brazening it out. Who knows what skeletons they are hiding under their “Level 3″ accounting.
It’s pretty simple, really. The nice people at GS figured out that people were being idiots with subprime mortgages and sold people lots of rope to hang themselves with. Their profits come from massive short positions in sub-primes. The cool thing about Wall Street is that if you look around and see people being massively stupid, you can usually figure out a way of making money from it. You yourself said that it should have been obvious that something was going to break. Once that is obvious, the next step is to figure out how to make mega-bucks when it does…….
You have to ask yourself when you see reports of massive losses. Who are these folks losing money *to*?
50 Cent: Thats an exaggeration. In a liquidity crisis there are FEWER buyers and they demand bigger premiums. Why this is surprising to anyone is not clear to me.
To have a market, you need a buyer and seller. If you don’t have both, then you don’t have a market.
In a liquidity crisis there no transactions going on since buyers and sellers can’t agree on a price. If you have a situation in which the price just goes down but people are still buying and selling at the lower price, then you don’t have a liquidity crisis. If they buyers are demanding low prices, and there are no sellers at those prices, then you have a problem.
50 Cent: Thats a very self-serving argument for Wall St don’t you think? If the casino gives you chips to play on the house will that increase or decrease the size of your bets?
Just because an argument is self-serving, doesn’t make it wrong.
In any case, investment banks are going to lose money on sub-primes, and no one is suggesting thatt this isn’t a good thing. If someone loses money on because they invested money in sub-primes because of a problem in sub-primes, that’s a good thing. If someone loses money on something that has nothing to do with sub-primes (like asset-backed commercial paper), this probably isn’t a good thing.
50 Cent: And apart from the economic costs there is also the basic issue of fairness. Why isn’t the government bailing out *everyone* who has financial difficulties?
The trouble is that if you don’t bail out people whose troubles have nothing to do with the initial problem, this hardly seems fair. If someone loses their job because the company they work for had their money in a bank that went under, this isn’t fair.
I think we can summarize our differences in two points
1) Investment banks just can’t do what Enron did because there are too many internal and external checks and balances.
2) I think that the Fed did the right thing, because it started to look like that people who had nothing to do with the initial stupidity were starting to get hurt. In particular once you started having problems with asset-backed commercial paper, this was worrisome because ABCP’s have nothing to do with subprime mortgages.
Twofish: “Trouble here is that ABCP’s *aren’t* backed by housing assets. ABCP’s have nothing to do with subprime mortgages other than the fact that you had the same investors in both.”
And you know this how?
Twofish: “Just because an argument is self-serving, doesn’t make it wrong.”
No but it certainly doesn’t make the argument right, and it makes it really suspicious. Especially for the outrageous claim that moral hazard doesn’t exist that plainly goes against our collective knowledge from hundreds of years in insurance and banking.
Twofish: “The trouble is that if you don’t bail out people whose troubles have nothing to do with the initial problem, this hardly seems fair. If someone loses their job because the company they work for had their money in a bank that went under, this isn’t fair.”
Are you serious? This is so loopy I scarcely know where to begin. Are you really suggesting that the government should insure every single business in the country against loss?
Re: the actual rate of inflation.
Well, in Canada lots of people are complaining about housing, food, and fuel costs. n.b. Canada’s housing bubble hasn’t burst yet.
A sarcastic, “Yeah, right!” is the typical response when people are told that inflation is “under control.”
One thoughtful person said to me, “they fudge the numbers so they can shortchange all those pensioners.”
God, somebody think China leaders are smart. I think they are smart only at keeping their ruling, not anything else. they are smart at political crackdown, internet censorship(so I have to write in english, cus all sites talking about politics in chinese are censored), rolling tanks to Tiananmen square, not anything else.
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