Richard Iley on the US current account deficit
Richard Iley
Brad Setser: Richard Iley of BNP Paribas – the author, with Mervyn Lewis, of a new book on the US current account deficit — doesn’t see the world quite the way I do.
I put a lot of emphasis on the importance of central bank financing of the US external deficit; Richard argues that I overstate the role of the official sector. I have also argued that large deficits eventually imply a deterioration in the US net international investment position and a negative "income" balance in the current account. Richard isn’t convinced – and the data has gone his way over the past few years.
But rather than try to summarize our differences, I am just going to turn the blog over to Richard Iley himself. Monday’s current account data will offer me a chance to expand on my own views. There is nothing like a bit of intellectual debate to make what might seem to be a dry data release come alive.
Richard Iley:
First, let me thank Brad for this opportunity to ‘guest blog’ at RGE monitor; not many would deliberately invite and welcome opposing views in the way Brad is happy to. I only hope I can rise to the occasion.
I wanted to begin with a little deep background ‘colour’ on how my thinking on the current account deficit has evolved. Apologies for the length of this post but I figured I may only have one shot!
Back in 2004, like most macro-economists, I was increasingly alarmed by the trajectory of the U.S. current account. Brad, of course, was in the vanguard of highlighting and amplifying these concerns. The shopping list of concerns over the deficit is a familiar one so I won’t repeat it. Suffice to say that I was so worried that I was prepared to take the ultimate radical step: write a book on the subject! But this project combined with the surprisingly benign out-turns of recent years has slowly produced a conversion on my part. My fears over the current account deficit, while not completely disappearing by any means, have slowly receded somewhat. Certainly, I have become more relaxed than Brad about the implications of, and prospects for, the US deficit.
Crucially, working with my co-author, Professor Mervyn Lewis, gave me an Antipodean perspective on the US deficit. ‘Down under’, extreme concern and unsuccessful attempts to target the current account deficit have progressively been replaced with a policy of benign neglect and recognition that, in a world of stepped up capital flows as home bias declines, current account deficits can largely be left to look after themselves. Provided a deficit (or surplus) is largely a private sector phenomenon (which it currently is in the US), it is essentially a matter between ‘consenting adults’ and so not a cause for explicit policy concern. We all have current account positions – some in surplus, some in deficit. If individuals and companies in a given country want to borrow and the rest of the world is happy to lend, why should this be a particular source for concern?
We need to be very clear; this is not to claim that deficits do not somehow matter or certain consequences are not likely to follow from them. Of course, they do. But rather, they need not be a matter of explicit policy concern. To couch it in Australian terms, the ‘larrikin’ will wake up with a hangover while the ‘wowser’ will enjoy a clear head: both tend to get what they deserve. We should only care about their behaviour to the extent, it impacts on us. In other words, there are clear and tangible externalities in the borrowing process. I’m not sure that this case can made on the US deficit, nor is, say, Oliver Blanchard. The emergence of the ‘consenting adults’ view is most associated with two leading Australian economists: Corden and Pitchford. This recent RBA paper gives a fascinating, and extremely readable, overview of the evolution of the debate over the current account in Australia.
Just as the ‘consenting adults view’ offers a useful armature for thinking for believing deficits/imbalances in general terms can be less threatening than first blush may suggest, evidence has steadily accrued over the last couple of years that the US deficit itself is less threatening and worrisome than I believed three years ago.
Above all, developments that seemed automatic back in 2004 simply have not happened. Metrics of sustainability have not deteriorated and have, remarkably, even improved in some cases. Specifically, the US’s net stock of external debt – the so-called net international investment position or NIIP – has increased to just over -$2.5 trillion in 2006 but, at around -19½% of GDP, relative to GDP it is no worse than in 2002! And relative to exports – the ultimate metric of sustainability – it has actually improved from a peak of 205% of export revenues to 165% in 2006. Moreover, a further improvement in 2007 looks on the cards. Nor has the investment income balance deteriorated as widely expected. Three years is a long time to be wrong!
Two other key factors have also worked to increase my degree of comfort over the deficit. The $ has obviously now already fallen a long way, particularly against the G-10 currencies. The fact that it has fallen so far without its drop becoming a rout to my mind has greatly reduced the chances of a sudden plunge or ‘Wile Coyote’ moment. For the latter to happen, exchange rate expectations would, I suppose, become extrapolative rather regressive. This can always happen but, given that ‘adjustment’ in the US deficit is now clearly underway, surely this becomes less, not more, likely. From its peak of -6.8% of GDP back in late 2005, the deficit has already narrowed by around c.1¼% points with this year’s $ depreciation and deteriorating US growth prospects promising more to come next year. And without the impediment of near record oil prices, the adjustment process would be even more advanced.
All told, the US deficit, now clearly retreating, looks more sustainable and has been more easily financed that seemed plausible a few years ago. The road ahead is still a long one but the journey home is now well under way. Rather the deficit prompting a painful recession as feared, it seems that US recession (or at least an extremely weak economy for some time to come) will prompt continued adjustment in the deficit.
The imminent release of the Q3 current account data – next Monday – will provide us an important update on these trends. Given we already know the trade deficit data for Q3 ($692.6bn annualized vs. $713.7bn annualized in Q2), expectations for the overall deficit are in a relatively narrow range. I expect a deficit of around of $188bn (market consensus currently $182bn). Relative to GDP, this would leave the deficit at 5.4% of GDP; the smallest since 2004Q3. While a Q3 deficit of this size would represent a relatively modest improvement of almost 0.2% of GDP from Q2’s level, it should nevertheless underline that adjustment is progressing.
Importantly, the petroleum deficit widened by an annualized $20bn or so in Q3 meaning that the ex-oil deficit improved by an additional 0.1% of GDP better. The oil price remains the ‘joker in the pack’ of current account adjustment in the coming months. A sharp fall, say sustained $20 per barrel drop, would dramatically accelerate the current account adjustment already in train. Here’s a useful ready reckoner. Oil demand seems to have stabilized around 3.7 billion barrels per year. A $20 drop would therefore generate a $75bn or roughly 0.5% of GDP improvement in the trade balance. Nice if it happens! Of course, this cannot be relied upon. The conventional wisdom is that the current account deficit needs to fall back to around 3% of GDP to be sustainable over the longer run (assuming a 6% nominal GDP growth rate, this would stabilize the US’s NIIP position at 50% of GDP), meaning another 2¼% of improvement in the current account balance will ultimately be required. The adjustment seen thus far is only about 1/3rd of that required so I an under no illusions that the road ahead is a long one and that the $’s fall so far may not yet be sufficient to ensure long-run sustainability.
The other two components of the current account are, of course, the investment income balance and unilateral transfers. My expectation for a c.$188bn deficit in Q3 is based upon a roughly unchanged $10bn surplus on investment income and a -$25bn deficit on unilateral transfers (roughly the average of the last four quarters). It is the continued resilience of the investment income balance in the teeth of external indebtedness that remains controversial and on which Brad and I first crossed swords just over a year. Importantly, the longer it stubbornly refuses to slide into the red, the less the trade deficit needs to improve to ensure sustainability so the outlook for this component of the current account is of great importance.
The US’s uncanny ability to both continue to generate a positive net investment income flow from a position of substantial external indebtedness and also to escape the full balance sheet consequences of its record current deficits essentially derive from three inter-related factors.
the enormous scaling up of both sides of the US’s external balance sheet with both assets and liabilities soaring relative to GDP as gross capital flows have mushroomed, magnifying the impact of outperformance of US-owned assets;
the very different risk characteristics of these burgeoning pools. The US overseas assets are dominated by ‘real economy’ FDI and equity assets, its liabilities much heavily skewed towards bonds;
the ‘privilege’ flowing from the dollar’s reserve currency status, which allows the US to borrow in its own currency and invest in other, leaving the US implicitly short its own currency.
The US’s strategy has worked exquisitely in recent years. Global growth has been strong (boosting equity and FDI returns), inflation has been low (capping interest rates) and the $ has generally depreciated. In turn, the US’s net investment income balance has taken on a Janus-like quality, with accelerating net returns on FDI more than outpacing steadily increasing net interest payments to the rest of the world.
A year ago I saw little reason to expect this propitious situation to end anytime soon. Nor has it. And conditions look set fair for yet another repeat performance in 2008. US growth (and so presumably US real economy assets) will under-perform growth in the rest of the world while interest rates and possibly the $ are falling. Looks like the bus has been cancelled for another year and all the time, as stressed above, adjustment in the overall deficit continues.
Of course, the US’s luck (skill?) cannot hold for ever. Implausibly large increases in leverage will be needed to sustain the outperformance of the investment income balance over the medium term. Moreover leverage can (and frequently does) cut both ways. The different risk and liquidity characteristics of the US’s balance sheet also mean that different payouts can ensue from different, future states of the world. A scenario of, say, global stagflation and a sharp appreciation in the trade-weighted $ is, of course, the nightmare combination for the US. But this is not my base case.
As an aside, the fact the UK manages to sustain a 1.5% of GDP net investment income surplus in the teeth of a NIIP of -20% suggests that the US’s persistent surplus may not be the unique perversion it is often regarded as.
I’m sure Brad accepts much of this and I know he has posted regularly on the importance of the second asymmetry in sustaining the investment income balance. But I feel strongly that the importance of the first and third asymmetries have been significantly appreciated and deserve much fuller comment. The explosion of gross capital flows and the underlying drivers of financial liberalization, globalization and declining home bias that drive it, in particular, has been unfairly ignored. Not only has this process of ‘scaling up’ been crucial in enhanced the US’s ability to lever its implicitly ‘long’ equity & G-10 currency, ‘short’ US dollar and debt position but it has left the financing of the US current account remarkably stress free in recent years.
As stressed in his introduction, the importance of these flows and the role played by central bank finance plays is where Brad and I genuinely part company. Brad tends to see private inflows and outflows roughly canceling each out, leaving the net financing position of the US largely dependent on an unnaturally stepped up level of ‘official’ central bank flows. I regard this distinction as essentially bogus as it requires comparing a gross flow – central bank purchases – with a net balance – the current account position.
Here’s a simple example. Assume the US needs current account financing of $1 but also invests $1 of FDI overseas. Its net financing need is, of course, $1 but its gross requirement is $2. Assume the US sells $2 of bonds to finances itself. A European insurance company purchases $1 and an Asian the $1. Can we say who is financing the current account deficit? I don’t think so.
Moreover, I would argue that when properly anchored in the context of record gross overall capital flows, central bank flows don’t appear particularly high. Rather than bemoan the US’s supposedly brittle reliance on ‘official’ finance, I think we should focusing on the US’s unheralded ability to attract private capital inflows on a scale unprecedented in history for such a large economy. The BEA data over the last year reveal how enormous gross capital flows have become. In Q2, capital inflows into the US were a mind-blowing $2.48 trillion annualized or 18% of GDP! Never before has so much capital flooded into the US. Nor is this a quarterly flash in the pan. Given the inherent volatility of the quarterly capital account data (something to bear in mind when thinking about the Q3 data), let’s look at average inflows in the year to 2007Q2. These averaged a record 16.3% of GDP over the last four quarters.
To put this in context, gross inflows into the US in the 1990s averaged 5.0% of GDP! And what is the composition of these record capital inflows in terms of the split between ‘private’ and ‘official’? In Q2, private capital inflows were a huge $2.201 trillion (16% of GDP) while ‘official’ inflows were a more modest $280bn annualized; almost ten times as large. Brad is convinced that these BEA data are a serious underestimate and will be revised higher. I have some sympathy with this view but even if they are, the fundamental picture would not be changed.
No-one questions that official inflows are undoubtedly high in absolute terms but the strength of these flows surely needs to be measured against the incredibly elevated level of total capital flows currently prevailing. As a proportion of total capital inflows, the latest BEA data suggest that the size of ‘official’ flows is basically ‘normal’. Their long-run (1977-2005) share of total inflows is about 16%. In the year to 2007Q2, they accounted for just 19%. Looks normal to me!
Like inflows, the scale of US capital outflows has exploded. Capital outflows amounted to an annualized $1.877 trillion in 2007Q2. Smoothing the data over the last 12 months shows that the latest quarter is no aberration but part of a secular trend. Over the year to 2007Q2, they averaged $1.418 trillion or 10.5% of GDP. Referring back to the private inflow data detailed above, we see that, in Q2, private capital inflows exceeded outflows by around an annualized $300bn in Q2 and, over the last year, by some $368 billion ($1.786 trillion of private inflows vs. $1.418 trillion of capital outflows). The ‘Setser’ way to cut the capital flow data over the last year is therefore to argue that the $793 current account deficit over the last year has been financed roughly ‘50/50’ by net private capital ($369bn) and ‘official’ flows ($416bn). And of course if central banks flows are under-recorded, then the role is even more important.
But this is simply one of several ways to compare the gross flow and net balance data and so make generalizations about the financing of the current account. Alternatively, it would be wholly correct to argue that that central banks’ ‘official’ purchases have financed around 30% of record US investments abroad over the last year while surging private capital inflows financed the remaining 70% and, of course, all of the current account deficit. The implications of presenting the data this way are quite startling. For example, if central banks stopped buying $’s overnight, the US would need to cut its current record spending on overseas assets by around 30% (from 10.5% of GDP to around 7% of GDP and it should be remembered that US capital outflows as recently as the 1990s only averaged 3.5% of GDP) to finance the current account deficit, assuming an unchanged rate of private inflows.
The obsession with ‘official’ inflows into the US seemingly arises from two controversial conclusions. First, that central bank purchases are somehow special, if not outright ‘abnormal’. Flowing on this is the usually tacit but sometimes explicit assumption that central bank purchases may prove more ephemeral or footloose than more inherently normal private capital flows. Both assumptions are highly dubious. A counterweight to the first argument is that central banks may be serving as financial intermediaries, compensating, in the case of China for example, fro immature and callow financial systems.
‘Special’ or not, it also highly questionable whether central bank finance will be more footloose than private capital flows. More likely, with considerations of profit and return less important than for private investors, central banks are unlikely to affect violent shifts in their portfolios. Not only would such an act crystallize significant capital losses on central bank’s existing holding, it would also increase upward pressure on their currencies; the avoidance of which was a key motivation in acquiring US financial assets in the first place. Rather it is more likely that private investors, whose prime motivation in buying US assets is more likely to be purer considerations of expected return, will prove the more footloose. Central bank selling of US assets may exacerbate any possible US financing crisis but it is unlikely to trigger it.
Viewed in the proper context, current account ‘concerns’ should properly crystallize around the US’s reliance on record private, rather than ‘official’, inflows in financing its deficit. The spotlight therefore now turns inevitably to the sustainability of the current record pace of private capital inflows. If the US can continue to receive private inflows anything like on the scale it has seen over the last year then financing strains should continue to be almost entirely absent.
Here the composition of the record inflows over the last year matters. One cause for concern is that short-term bank lending flows, clearly the most footloose element of capital flows, have picked sharply over the last year. Indeed, at 6.9% of GDP in the year to 2007Q2, they have begun to outpace FDI and portfolio investment inflows for the first time in over twenty years. But the apparent reliance of these flows may be less threatening than it appears. Banks of course make money by using their short-term low yielding liabilities (i.e. deposits) to acquire longer-term, higher yielding assets: in the jargon, ‘maturity transformation’.
With deposits flooding in the year to 2007Q2, US institutions have understandably put this money to work in higher yielding foreign investments. The explosion of US investment overseas over the last year is therefore probably the other side of the coin to the record bank inflows that the US has received. If one dries up so may the other, leaving the US’s financing position essentially unchanged. I suspect that this is what the Q3 capital account data on Monday will essentially show; Brad will probably see it differently. The moral of the story must be that the asset and liability sides of the US national (or any) balance sheet cannot be viewed in isolation.
I, as usual, have said more than enough. But two final points in conclusion.
First, the lesson of recent years has been that foreign demand for US assets – both private and ‘official’ – appears more structural and hence more sustainable than anyone thought. The question ‘what is the price of money?’ is a very difficult one for economists to answer. But the marginal productivity of holding $’s appears to higher than most economists believed.
Second, capital flows can reflect either or both of two separate and distinct phenomena – reallocations of portfolio stock and allocations of newly created wealth in established patterns. The former occur in response to changes in current and expected yields and in perceived risks. They are essentially one-shot effects. A key question is whether the $ has now fallen enough to prompt big stock adjustments and if so in which direction. $ positive or $ negative? I know Brad will have strong views.
Brad, thanks for inviting Iley to present his views. His is a very interesting argument that I, personally, have always found pretty convincing.
The (accounting) argument that the net dollar flows comprise 30% CB purchases and 70% private is bogus. Lets look at reality (not financial slight of hand).The US deficit was/is? around 750B, so 30% of this would be 225B.
The growth of Chinese dollar reserves was until very recently running at 400B per year. Assuming that this is mostly T-Bills and not just dollar bills stuffed into mattresses, then by my reconing 400B is around 55% of 750B.
Thus,unless someone else is printing dollars, then the Chinese central bank alone accounts for 55% of dollar purchases. Add to this the rest of the BRICs and it starts to look like the balance is more 70/30 in favour of the central banks than 30/70.
The US: The mother of all hedge funds.
Thank you for posting Mr Iley’s presentation. As much as I want to believe Mr Iley, my instinct (fear?) tells me Brad’s view is more compelling. These are interesting times and the next few months will hopefully bring more clarity to which position best describes what is happening in the global financial market. Again, thank you posting Mr Iley.
“Certainly, I have become more relaxed than Brad about the implications of, and prospects for, the US deficit.” I feel this statement might just come back to haunt him…
As a currently timid holder of only cash, who once did alright with a handful of mutual funds from 2002-06, I appreciate calming views from someone who thinks we aren’t so bad off now. But I didn’t see where Mr. Iley’s compass is pointing. Words like inflation, asset inflation, liquidity bubble and “printing press” never appeared. Where are we going from here, or do I have to buy the book?
http://www.nypost.com/seven/12132007/business/ben_must_be_really_worried_about_the_eco_876115.htm?page=2
The big problem is nervousness in Europe and Asia, where economies as well as currencies are doing better than ours.
If that trend continues, interest rates overseas will be more attractive and foreign assets will flee the US - especially if foreigners continue to risk losses because of the weak dollar.
If all that happens, the US will lose control over its own interest rates and economy.
The point is, for months the Fed has found itself with only bad choices.
That’s likely why Fed Chairman Ben Bernanke has been playing down the idea of interest-rate cuts at a time when he should be aggressively making money cheaper.
So it’s not surprising that the Fed is going to Plan B - liquidity injections in coordination with foreign central banks rather than bigger rate cuts.
By now Wall Street should have figured all this out.
who cares about the net financial position at market rates ?
How did the financial net position of US homeowners go before the housing bust ?
Let the europeans stock markets fall to reasonnable levels (a PER of 16 would mean a fall of 30% of current prices)… then you have a horrendous net financial position at market prices.
THe financial net position at market prices says nothing, what s interesting is flows at PPP prices.
And same goes for asia.
Richard: technically, me measure of official flows is a net concept — Gross inflows - gross outflows. But since US official outflows are trivial, it reduces to gross inflows. I agree with Norman’s dog: that number is understated in the recent data. Basically, $300b annualized in official inflows seems a bit low for a single country (China) given its reserve growth, and way too low for a world with $1.1 trillion in reserve growth and $100b of new inflows to Sov. wealth funds over that period. I think you would agree with this at least directionally, but I would be curious what you think the right number for “official” flows (gross inflows, but that becomes net absent US intervention).
Some of the difference is explained by offshore $ deposits (themselves available to finance securities purchases by other intermediaries), but some in my view is simple undercounting of debt purchased through London and then sold to big central banks/ the failure of the US data systems to pick up official funds outsourced to private fund managers. The first leads to an undercounting of Russian/ Chinese purchases, the second to a failure to capture most gulf inflows. I personally would expect the survey data to revise measured official inflows (through q2) up to $500-600b (somewhere around 4% of US GDP)– still an undercounting, but a much larger share of either the gross or the net.
As you know well, the current account balance is also a net concept — gross receipts (on trade, income and transfers) - gross payments. A deficit in the current account requires a net inflow of capital. Any student of emerging economies knows that if NET private flows disappear (whether b/c of a fall in gross private inflows or a rise in gross private outflows), the current account has to adjust if the gap isn’t covered by a NET inflow from the official sector.
Jim O’Neill of Goldman makes this point quite effectively.
In that sense, i think it is useful to compare net official inflows to the net balance on the current account — it emerges from another accounting identity: the current account balance is equal to the capital account balance, and the capital account balance can be disaggregated into the net balance on private flows and the net balance on official flows.
That said, it is a bit artificial to say this dollar of official flows finances the current account deficit and this private inflow finances private outflows. in broad terms, it is all money coming in and money going out. Indeed, in the 60s — back when the US really did operate more like a hedge fund and less like household borrowing against their home equity to finance a low rate of savings — (gross or net) official inflows financed (gross or net) private outflows. Global reserve growth financed US FDI abroad, to France’s notable dislike.
It consequently can make sense to look at a country’s gross financing need — the expected current account balance (5.5% of GDP, maybe a bit more for q4) + expected private capital outflows (10% of GDP?). Then you have to plot out expected private inflows (10% of GDP). The result in IMF terms is a financing gap (15.5% going out, 10% coming in) — one that has to be filled or the country has to adjust.
Now you would argue, correctly, that the adjustment could come from either smaller gross outflows (10% goes to 5%) or a smaller deficit — true enough. But my experience with countries facing a shortfall in private inflows is that private outflows did to go up not down in times of stress. Argentina is a case in point — funds fled argentina in 2001 in a big way, with private outflows generating far more pressure on Argentina’s “official” holdings of assets than the current account deficit.
So realistically, absent official financing, the balance on private capital tends initially to get worse not better in times of stress — capital flight.
Now you can argue that this all doesn’t apply to the US — because the uS remains a safe haven and folks will want to hold more dollars in times of stress, not less. Americans will cut back on their desire to hold european and em equities for example. Maybe. But I don’t see any evidence of a reduction in private US demand for foreign securities yet.
Ultimately, the availability of official financing to make up the gap — in my view — is central to the overall equilibrium.
Here though I wouldn’t generally include the lines in the capital account representing bank flows (what would normally be reported as “other investment” in the standard capital account presentation), at least not for the US. these lines (liabilities reported by banks and non-banks) are huge, but for the uS, they systematically tend to cancel out. I think there is a reason for this: the global banking system isn’t building up an unhedged $ position, taking in euro and rmb and yen deposits and buying US securities. that contrasts with say Eastern europe, where European banks lend to the country in euros, providing a net inflow through the banking system w/o taking an unmatched position.
Once those flows are netted out, there hasn’t been a real uptick in gross inflows — not on the private side. gross FDI and gross portfolio security inflows are about where there were in the .com era (v. US GDP). What has changed since then?
Well, more outflows from the US, and more official inflows.
Basically can I say that Mr Iley believes that US can inflate out of this crisis because the USD’s dominant position in the international trade?
Richard — re: the net international investment position. It is hard to argue with facts. You are right that the NIIP hasn’t deteriorated since 2004 — throwing the Roubini/Setser projections way off. In that paper we explicitly noted that we didn’t try to estimate capital gains from $ depreciation. What we didn’t note was that the US could also experience capital gains if foreign equities outperformed US equities.
Those capital gains effectively represent the outperformance of foreign markets relative to US markets in dollar terms ($ depreciation = appreciation of others). Very little comes from a large portion of the United States gross asset position — most US lending to the world is in dollars, and seems to be fairly short-term. And very little of the gain has come from post 2000 flows into FDI and foreign equities. Relatively speaking most simply comes from two things:
a) foreigners bought into the US equity market late .. and took losses from the .com crash
b) the US has a ton of accumulated investment in Europe that has soared in value … (it incidentally doesn’t have near as much investment in asia or the emerging world)
the flip side of this of course is that the US has had to attract a net inflow of capital (more inflows than outflows) despite systematically offering lower returns than investment in the rest of the world.
and to make it all the more challenging, it had to do so when emerging markets got their act together — so Russian savers started preferring ruble deposits to dollar deposits, Chinese savers moved funds offshore back onshore and shifted from domestic dollar deposits to rmb deposits, and Eastern europe dedollarized and euroized. The old safe haven private flows here have reversed — look at the net private inflow to Russia, or China.
Who made this possible? My answer is fairly simple — to a limited degree, yen carry trades financed by Japanese households. from 02-to early 04 this was an official flow, but now it is a private flow (tho one now going more toward your friends in antipodes), and from the emerging world, a largely official flow.
most of the big gross flows between the us and europe seem to be in dollars and to cancel each other out — think a Citi entity in London selling subordinated notes to US investors to finance the purchase of US ABS, or a CDO set up offshore that buys MBS and sells tranches to US investors. They don’t seem to represent the assumption of $ risk by Europeans or provide much net financing (logical, b/c europe as a whole doesn’t have a big surplus).
I am simplifying a bit — US investors have been buying European equities unhedged, and Europeans no doubt have done the same. There may even be a net long dollar position somewhere in europe as Europeans concluded the dollar was cheap and it made sense to buy (a ton of official money is also flowing into the eurozone, and in aggregate, it is financing a private outflow, not a current account deficit — tho i would bet more of the outflow from the eurozone is going to eastern europe financing deficits there than to the uS). And there are dollar inflows into Europe from the emerging world (often the official sector) than are available to buy US securities.
But that doesn’t seem to me to be the flow that is sustaining the United States ability to fund a big external deficit in $ — which implies the buildup of net $ longs outside the US. That big long position seems to me to be found in emerging market central banks.
One small point on the income balance — the rate of return on foreign direct investment in the US is incredibly low (below the return on treasuries), and the gap in the rate or return, not the difference in stocks, explains most of the FDI income surplus.
Daniel Gros has explored this, and found that most of the gap comes from differences in reinvested earnings (there are lots of reported reinvested earnings by US firms in Europe, who don’t pay tax in the us so long as the funds remain offshore, but very few from European firms operating in the US). Your bank must have some insights into all this! What do you think — does the gap reflect tax arbitrage, as European and US firms prefer to show profits in low tax European jurisdictions (Ireland, the Netherlands, Switzerland) or a real gap in the rate of return on US FDI in Europe v European FDI in the US?
If the gap is real, it suggests the US is actually a very bad place to invest — which ought to cut into its ability to attract ongoing inflows ….
The interesting question seems to revolve around the role of official capital inflows in the funding of the US current account deficit.
There is a concept in behavioural economics known as ‘mental accounting’. It is generally applied to consumer finance and has to do with the false compartmentalization of cause and effect in the dynamics of income statements and balance sheets. This idea can be applied to the question at hand.
Specifically, as you point out, and as Brad seems to partially acknowledge, it is somewhat artificial to insert a net flow cause into a gross flow outcome. It becomes a convenient but not necessarily accurate frame for explaining the dynamics of central bank involvement in capital flows. Do official inflows finance the current account deficit or capital outflows? Does this question really have any meaning?
I think the answer may lie at the source. There is a tendency to confuse what are essentially two distinct steps in the central bank role. The first is foreign exchange intervention. The second is the official capital flow outcome. The first has an effect on exchange rates. The second has an effect on capital flows.
It is important to recognize that the first is necessary for the second. In this sense, the central bank role is Bayesian. Official flows are conditional on foreign exchange intervention. And in this sense, we have fertile ground for false counterfactuals.
What if official flows dry up? Well, that means that intervention must dry up. And that probably means that the exchange rate complex will change. And that probably means that the current account complex will change. A legitimate counterfactual must be multi-dimensional and is therefore correspondingly highly speculative. But more importantly, counterfactuals, while not driven by accounting identities, must be constrained by them.
Specifically, according to accounting identities, the drying up of official flows means the drying up of foreign exchange intervention, which means larger private holdings of foreign exchange, which means via current account identities larger private flows. Conversely, and most importantly, official FX intervention is the cause of private holdings of FX being lower than would otherwise be the case, and given the accounting identities, causes private capital inflows to be ‘inadequate’ for the financing of a particular deficit.
So the false counterfactual that private flows will be inadequate if official flows dry up is a sort of corollary to the false construct of mental accounting when it comes to attaching official capital flows to a particular aspect of the entire financing profile. Shortfall of private financing (at a prevailing exchange rate) is the result of proactive central bank foreign exchange intervention - not the cause of official capital flows.
The question of risk to official inflows is a legitimate one. But before answering it, one must consider the effect of a corresponding decrease in foreign exchange intervention, and a corresponding shift of dollar balances into private hands that must do something with them (by accounting identity - otherwise the counterfactual is contradicted). Certainly the exchange rate will be affected with all of its possible knock-on consequences for the size and allocation of all sorts of flows. But current account financing will muddle through. It has to because the outcome is constrained by accounting identities. So I’m more with Richard than Brad on this.
Brad has noted a number of important qualifications to the size of the problem in its various aspects, including the likely statistical understatement of the current level of official inflows, and likely data problems with NIIP. But scaling (dark matter), risk transformation, and currency privilege are all fundamental factors that reinforce the importance of dealing with the issue on an integrated, gross flow basis rather than through the mental accounting construct of linking official capital flows uniquely to the marginal financing of the current account deficit.
US Trade Deficit to fall with Consumer Spending Binge over
From Peter Schiff,
http://www.europac.net/newspop.asp?id=10905&from=home
In an article this week that examined the troubles brewing in Citigroup’s mortgage business, the Wall Street Journal focused on Natalie Brandon, a 51 year old married woman from Granada Hills, CA, who is currently unable to make the payments on her $625,000 adjustable rate home loan from Citigroup, despite the fact that the rate will not even reset higher until June of next year. Amazingly, the Journal reported that Mrs. Brandon bought the house in 1985 for just $105,000, but had chosen to refinance five times over the past seven years, borrowing more than $500,000 and spending every single penny.
For years, Wall Street and the media have been singing the praises of the heroic American consumer. To that end Mrs. Brandon could be portrayed as Wonder Woman. She did her part to power our consumer driven economy by borrowing and spending to her heart’s content. Her last refinance even allowed her to buy a brand new Lexus. As long as she could find a greater fool willing to loan her more money, there was no limit to what she could buy. As it turned out, Citigroup was the greatest fool, left holding the bag on a $625,000 mortgage on a house now likely worth only half that amount.
Is it any wonder that we have enjoyed such a vibrant consumer based economy when a working class couple with perhaps $60,000 per year of household income can borrow over $500,000 (tax free) and buy whatever they want with the money? As the bills come due and those who have been doing all of the lending finally realize they will never be repaid, this crazy consumption binge will finally come to an end.
I think I rather forgot my own rule for comments — namely keep them short. But richard’s post was long — I encourage others to weigh in as well, though preferably with out going into the weeds as much as I did!
I am particularly interested in the gross v net debate, and to what extent the rise in the gross reflects tax/ regulatory arbitrage and the like, i.e. offshore entities issuing $ debt to us residents to buy US securities, pushing up gross flows without generating any net flows while shifting the profits from financial intermediation to low-tax jurisdictions.
Quote of the Day from Russia’s Vladimir Lenin:
“The best way to destroy the Capitalist System is to debauch the currency. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless: and the process of wealth-getting degenerates into a gamble and a lottery.” - Vladimir Lenin, 1922
How Ironic that the China PBoC is trying its best to support the monetary value of the US Dollar by purchasing Treasury bonds, while Federal Reserve Ben Bernanke debauches the US currency by recklessly printing so many dollars?
Vladimir Lenin should be turning in his grave. Chairman Mao too. - DC
“the US is actually a very bad place to invest” - i’m repeating a question, but what exactly do you mean by this, given the very global nature of the ‘U.S. economy’ and ‘U.S.’ assets (which still account for - at least about half? - of ‘world’ assets?)
apart from the fact that the value and ‘health’ of U.S. assets and entities seem to underlie the relative value and health of everything else…
not-so-anonymous guest — Come on. A dollar invested in europe (Euro bonds/ MSCI Europe equities in say early 2003 is worth a lot more than a dollar invested in the us (USD bonds/ S&P US equities). and if you buy the data, fdi in the US (with smaller capital gains) earns (counting reinvested earnings) less than 4%, and US FDI in Europe “earns” something like 7%. That is what I mean. For all the talk of globalization, equities listed on the US exchange are still denominated in $ and get more of their profits from operations in the US than firms listed on European exchanges that are denominated in euros.
anonymous — I appreciate the thoughtful tho critical comment, and I suspect Richard will too when he has time to join in.
A couple of points in rebuttal –
First, anyone with experience in emerging markets would not assume that “current account” financing will always be there, whether from private or official sources. When the financing dries up, the current account deficit can also dry up — quite abruptly. sudden stops in capital flows (private ones) absent official financing can lead to sudden stops in economic activity and large (10% of GDP) current account swings quite quickly. The US is different, but not so different that something similar couldn’t happen — tho obviously the global impact of a comparable swing in the external balance of an economy as large as the US would be quite different, and the global transmission of the shock would likely help to limit its magnitude. (by which i mean the us slowdown would lead to a global slowdown that would make a host of assets, not just us assets, less attractive and eventually induce flows to the us that would limit the need for current account adjustment).
I agree with the observation that fx intervention precedes official capital flows (though here “saved” oil revenue that is handed over to the central bank or investment fund in fx is also important). But I disagree with the casuality implied in the argument “Shortfall of private financing (at a prevailing exchange rate) is the result of proactive central bank foreign exchange intervention - not the cause of official capital flows”. I would argue that the casuality is actually the opposite — shortfalls in private financing to the US lead, under the current system, to more official intervention. the net result is stabilizing, to be sure — but the central banks are reacting, not driving.
here is why:
a) a shortfall in private demand leads to downward pressure on the $ (notably v euro). a shift in SWF assets toward europe has the same effect.
b) the funds not going to the US go somewhere, often toward emerging economies
c) The dollar’s fall v the euro leaves emerging economies that peg to the dollar even more undervalued — making them more attractive destinations for private capital.
d) undervalued exchange rates induce a bigger trade surplus over time, providing more funds for the folks at the PBoC … but that plays out over a longer period of time, and is more tied to the level of the $/ rmb v the euro, not the change.
the net effect is that official intervention is correlated (in scale) with a fall in (net) private flows to the US and pressure on the $ v floating currencies. But absent the pressure, the official sector wouldn’t be intervening — so I would argue the official sector isn’t displacing private flows so much as making up for a shortfall in private flows.
“Suppose a middle eastern fund invests in a london [or U.S.] hedge fund. its money is intermingled with all sort of other money…”
if the Middle Eastern Fund invested in a US hedge fund, it would be recorded as an official inflow to the US (sovereign purchase of a us asset — namely participation in an investment pool). Harder case is if it invested in a Swiss fund of funds …
Still, if this was meant to refute my earlier point about US (dollar-denominated assets really) under-performing, it doesn’t.
Response to bsetser on 2007-12-14 12:07:47
I appreciate your receiving my critique in a constructive way.
I can visualize a hypothetical and perhaps theoretical scenario whereby the scaling factor that Richard refers to starts to reverse - i.e. gross capital inflows to the US begin to reverse resulting in a painful contraction of the international balance sheet, economic activity, and the current account deficit. This would be an influence of a contracting gross on the net. I assume that would be the analogue to the real history of emerging markets. As you say there could be a floor on asset prices whereby some new equilibrium was reached.
If I can use an intuitive, unsophisticated construct, I would think of this as a parametric shift in the size of the current account deficit (the parameter being gross flows and knock-on economic effect), whereby the ‘required funding’ for the deficit was still automatically forthcoming in the sense of the accounting constraint.
I’ll make a couple of more comments on causality of the official/private mix, although I’m sure we’ll have trouble meeting, and I do defer to your knowledge of economics.
I think of the causality of the central bank flows in the following sense. I would agree with you that the central bank intervenes because private flows are not forthcoming. But I would qualify that by saying that private flows are not forthcoming at the current exchange rate. We don’t know what private flows would do if the exchange rate were allowed to float. So my interpretation is that the causality is such that the central bank proactively intervenes to support the exchange rate, but then responds passively (i.e. effect rather than cause) to its own exchange rate policy by dealing with its consequences - i.e. deciding on the destination and asset category for the official outflows that it has forced on itself by its exchange rate policy.
To be honest I’m not sure I completely follow your final paragraph, probably indicating my inadequacy in economics. But to the degree that central banks intervene in the exchange market, not only are those dollars no long available as private flows to the US - they are no longer available as private flows anywhere.
On the other hand, private gross flows apart from those required to balance current account deficits are self liquidating by accounting constraint. Going back to the idea of gross capital inflows reversing out of the US as part of ‘de-scaling’ - such a reversal operationally does not necessarily require a 1:1 current account adjustment - a liquidation of gross capital inflows can be financed by a liquidation of gross capital outflows.
Again, I would have thought that the causality in terms of required official flows is that the private sector is unwilling to finance the US at prevailing exchange rates. But that’s connected to the fact that the prevailing exchange rate is not allowed to adjust in those countries that intervene. So the downward pressure on the exchange rate and the absence of private flows comes about as a result of the private sector unwilling to invest at that rate. But we don’t know what might happen at a more attractive but officially unavailable rate.
if you might be persuaded to tackle the Swiss - but to say that an asset is a U.S. asset simply because it is priced in USD - or that it suddenly ceases to be a U.S. asset simply by denominating it in another currency, seems a bit misleading to me…
Aha, say sustained $0 per barrel drop, would even more dramatically accelerate the current account adjustment already in train!:)
So, let me get this straight - Mr. Iley believes that there will be some rockiness ahead, but in the end all will be well because it has to be - we will all automagically come to our collective global senses and trust in the solidity of the consumer-spending driven fiat dollar once again.
Clap your hands if you believe in fairies…
Latest from Peter Schiff at Euro-Pacific Capital,
http://www.europac.net/newspop.asp?id=11061&from=home
This week’s announcement by the Fed that it will create a new mechanism to provide funding for credit challenged banks has been lauded by Wall Street as an innovative approach to solving the credit crisis. In truth, it is really just the same response the Fed has had for all problems great and small: crank up the printing presses, shower money on the problem, and hope that financial pain can be obscured by the balm of inflation.
The Fed and other foreign central banks will provide this liquidity by auctioning low interest rate loans to holders of U.S. mortgaged-backed securities. Since the loans can be collateralized by mortgage-backed securities, the Fed will be on the hook should these loans not be repaid. In other words, the losses will simply be monetized, or more precisely socialized, as they are passed to the public in the form of inflation.
To get a sense of the losses that potentially await the public, in a recent transaction, E-Trade Financial liquidated its entire portfolio of subprime mortgaged-backed securities for a mere 27 cents on the dollar! If mortgage losses are socialized through inflation, this new cure will be even worse for the economy than the “housing bubble disease” the Fed infected us with in the first place.
anonymous — you probably couldn’t understand my last paragraph because I packed a lot into it, and basically spoke in code. My own research suggests a pretty strong correlation between global reserve growth (ex petroleum states) and the euro/$. A weak $ v euro = more global reserve growth. I then interpreted this to mean that periods of weak private demand for us assets (i.e. the dollar is falling the euro, which floats) are matched by an uptick in official demand, and argue the connection goes from a fall in private demand to a rise in official demand (i.e. funds that formerly flowed to the us flow to other economies, including the asia, leading to a pick up in reserve growth) rather than the other way around — i.e. a rise in reserve growth leads to lower US yields and reserves are invested in the us, pushing private funds into better opportunities elsewhere in the world. But there is a debate about direction.
I agree with two of your points:
1) That we don’t know what all would change in the absence of official intervention. It is possible that a small fall in the $ and a small rise in US rates might induce a very large increase in private demand for US assets from private investors abroad (w/o any offsetting change in private demand for foreign assets from US investors), allowing a roughly similar deficit to be financed on roughly similar terms. Or it is possible that the adjustment would be more brutal — meaning a bigger fall in the $/ rise in us rates/ fall in the deficit would be needed to generate a “financeable” combination.
2) mechanically a reduction (a better term i think that liquidation) in gross private/ official inflows can be financed by a reduction in private outflows. Or to put it differently, net private inflows to the US could rise if gross private inflows to the US increased or gross private outflows fell. I would suspect though that the same forces that led to a fall in gross inflows would also lead to an increase in gross outflows (i.e. buy china before china revalues … ), at least initially. and only after the “adjustment” in 1) took place would gross inflows increase/ gross outflows fall.
I wouldn’t go as far as Richard does in looking at all gross flows — since it seems like a lot of the rise in the gross is entirely dollar hedged and tied to interbank lending between NY and London and the Carribbean in dollars, offset by similar inflows. So long as there is no net buildup of $ exposure, there will be no net financing — whether for a sustained capital outflow or a current account deficit.
So my accounting for 07 — based on the data we have seen so far — would have a roughly $750b current account deficit (q4 seems likely to be bigger than q3) and roughly $400-450b in net portfolio/ FDI outflows (resulting in an increase in US residents exposure to foreign currencies). To the extent this is financed in US dollars, it likely will be financed by a net inflow of $850b or so from the official sector (counting official assets handed over to private investors to manage, but with the proviso that they have to be in $, and counting SWF flows — so basically $800b from central banks and $50b from SWFs) and $350b in unhedged foreign inflows from private investors (i.e. folks who want the dollar exposure).
the fall in the US current account deficit in 07 has been offset by a rise in US demand for foreign assets, and relative to 05 and 06, foreign private demand for US dollar assets (demand that is unhedged) has fallen dramatically.
What I wouldn’t do is include a lot of the private flows that I think can reasonably be assumed net out.
http://www.stratfor.com/products/premium/read_article.php?id=299835
Many people will see this as a tilt in global power. When others must invest in the United States, however, they are not the ones with the power; the United States is. To us, it looks far more like the Chinese and Arabs are trapped in a financial system that leaves them few options but to recycle their dollars into the United States. They wind up holding dollars — or currencies linked to dollars — and then can speculate by leaving, or they can play it safe by staying. In our view, these two sources of cash are the reason global markets are stable.
Energy prices might fall (indeed, all commodities are inherently cyclic, and oil is no exception), and the amount of free cash flow in the Arabian Peninsula might drop, but there still will be surplus dollars in China as long as it is an export-based economy. Put another way, the international system is producing aggregate return on capital distributed in peculiar ways. Given the size of the U.S. economy and the dynamics of the dollar, much of that money will flow back into the United States. The United States can have its financial crisis. Global forces appear to be stabilizing it.
The Chinese and the Arabs are not in the U.S. markets because they like the United States. They don’t. They are locked in by US Dollar hegemony. Regardless of the rumors of major shifts, it is hard to see how shifts could occur. It is the irony of the moment that China and the Arabian Peninsula, neither of them particularly fond of the United States, are trapped into stabilizing the United States.
Needless to say I’m delighted at the response my post has generated and apologies for not being able to dive back in earlier. At this point, I’ll limit myself to a couple of points.
Brad’s point that the US’s ability to earn outsize investment returns is purely a function of differential FDI returns is absolutely right. In ‘Untangling The Deficit’ (sorry, couldn’t resist) we update CBO calculations and find that, since 1976, US-owned portfolio investments abroad have actually underperformed foreign-owned portfolio investments in the US, albeit marginally (average annual return 5.1% vs. 5.4). By contrast, returns on US FDI investments have far exceeded those on foreign-owned FDI into the US (average annual return of 9.5% vs. 5.9%).
Sadly I have no special insight into this conundrum but my strong pre-disposition is that much of it is ‘real’, reflecting a mixture of US market savvy (ability to sell assets at the top of market - think Rockefeller Centre, Pebble Beach), bad decisions on the part of foreigners (think a certain $30bn+ loss on investing in a US auto maker this year)and intangible cultural factors (John Kay wrote a fascinating article on this in the FT earlier this year - sadly I can’t find a link at this stage). Overall, my characterisation would be that the US is a tough, rather than lousy, place to invest. And for whatever reason, history seems to be repeating itself. I don’t want to go into specifics but there seem to be several high profile examples of FDI rushing into the US this year at what is almost certainly the top of the market. The rest of the world seems determined to continue to try to crack the US investment ‘nut’ despite a long history of failures.
More generally, as my concluding comments in my earlier post hinted at, the answer may lie in the unique characteristics of the $. I think to some extent we are still learning what the ‘price’ of a dollar truly is. Basic economic theory tells us that money of course has two prices - its purchasing power and the flow of services it provides. These ’services’ are in essence two-fold - it provides a store of value (so the capital gain or loss that arise from changes in its purchasing power) and is also a medium of exchange (the benefits money yields in convenience, ability to transact, effort saving etc). The $ may be proving to be a poor store of value but the strong secular demand of $’s by the rest of world suggests that the value of the $ to the rest of the world as a medium of exchange is much larger than thought.
This is simply a long-winded way of arguing that the ‘privilege’ - exorbitant or otherwise - of issuing international money is very substantial. Certainly much larger than I imagined a few years ago. The ‘privilege’ cannot be abused for ever but I have to be honest and admit that I do not know what the time scale of its decay will be - months or years?? Probably the latter.
Richard Iley
What if the US trade deficit and high oil prices are not coincidental? What if US$/reserve currency flows of 6% of very large GDP for a few years has incited excessive global monetary stimulus? What if the trade balance has only improved because the expansion of investment bubbles outside the US has started to outstrip housing/finance bubbles inside? What if this unprecedented global monetary stimulus found its bottle neck primarily in commodity prices for a time, but whose labor market honeymoon is coming to an end? What if all of this were true- would that change any of the evidence you’ve cited to make your case?
Of course financing a current account deficit is not problematic if you have a captive audience for your claims that will take whatever return is on offer (one paper estimated the post-Bretton Woods real return on external US$ debt liabilities at a heady .3%). That does not mean that the imbalance does not have side effects. Faced with a US economy creating huge quantities of claims, ROW had two choices: A) hold out for a better return/bank run, or B) monetize the debt. The rest, as they say, is history…
“the strong secular demand of $’s by the rest of world suggests that the value of the $ to the rest of the world as a medium of exchange is much larger than thought.” - Richard Iley
It’s called US Dollar hegemony. Since everyone in the world needs oil, and oil is priced only in US Dollars, everyone in the world accepts US Dollars. Despite being a special economic zone of China, Did you know that 95% of Hong Kong import and export trade is conducted in US Dollars? That is why the Hong Kong dollar still remains pegged to the US Dollar and not the Chinese yuan. The Chinese economy maybe the third largest GDP in the world but the currency isn’t accepted as a medium of international trade exchange.
Oh by the way Brad, US Dollar hegemony is true. I spoke to a retired State Dept officer, a friend of the family who was formerly stationed at the US Embassy in Kuwait. He confirmed that maintenance of US Dollar hegemony was in fact an objective of US military power projection in the Middle East and Central Asia. As long as oil is priced only in US Dollars, the US derives an enormous ‘privilege’ - exorbitant or otherwise - of issuing international money.
eurozone rail 15 and 30 day season tickets for non eurozone residents are quoted in u s dollars. (google to confirm this if you wish) it’s a simple matter of convenience.
i disagree with waterboarding and i do not like coca cola. george washington was not as good looking as george clooney. so what ? if you are not exactly a publicity hungry brazilian supermodel you should try to relate to the dollar rationally. the oil is quoted in dollars because dollars are a useful measure.
this autumn, in their different ways, china, europe, saudi arabia, iran, have indicated that they would be grateful if the dollar would take its role seriously. otherwise they are in imminent danger of getting no return on their dollar holdings. the wylie coyotes have seen the cliff edge. far from the wicked fed holding the global economy captive, the wylie exporters are arm twisting the fed to act like custodians of the almighty dollar - not like some mafia outfit counterfeiting transylvanian zlotys.
the root of the deficits is outsourcing plus printing money. i think that outsourcing for purposes of wage arbitrage is by definition deflationary, while printing money is inflationary. thus money printing which would otherwise have long ago ended in a messy inflation, and burnt itself out, is enabled to continue.
fiat currency + outsourcing = deficits. the remedy is one your president knows well. cold turkey.
i feel (intuitively) that the balancing factor is a strengthening dollar. so the creditors do not dump the dollar in a wylie coyote moment. they present the u s with a cuba crisis moment - i e if we don’t all back off this, we all get a radioactive shower.
dave chiang has actually taught me a lot. he has forced me to consider why he is so wrong. to use a different analogy - bernanke has watered the whiskey until the customers won’t willingly buy any more. saudi arabia in particular doesn’t see the point in drinking all night and still being sober. iran has already quietly left the bar. the w. coyote moment is over.
one element in the globalisers’ equation has to change. perhaps outsourcing plus strengthening dollar = declining deficits. that means real interest rates in positive territory, and bankruptcies.
if that is too much pain to bear - wait until the creditors’ pain is too much to bear, and we all jump off the cliff together.
if all of the above equations are mistaken, then something else has to give. any other suggestions ?
“Oil demand seems to have stabilized around 3.7 billion barrels per year”
It seems to me a counterintuative assumption. As long as there is real economic growth, as opposed to inflation, demand for oil will increase. On the basic assumption that economic activity is energy dependant. That’s the only reason I argue that oil price should keep climbing, provided there is’t sufficient supply to meet growing demand.
http://www.bp.com/liveassets/bp_internet/globalbp/globalbp_uk_english/reports_and_publications/statistical_energy_review_2007/STAGING/local_assets/downloads/pdf/table_of_world_oil_consumption_tonnes_2007.pdf
Global consumption from ‘96 to ‘06 increased by about 16%
China doubled their consumption in same period. I´m pretty sure that is firmly linked to their economic growth…
Oops! afraid I don’t know how to link properly. Sorry about stretching this all sideways.
Some additional comments late on Friday night after a long day.
Thanks once again to Brad for the opportunity to air some of my thoughts on the current account debate.
Surely relative to a year ago, with the current account deficit some 1.25% of GDP smaller, metrics of sustainability i.e. exports to NIIP improved, capital inflows stronger and the $ trade-weighted $ substantially lower (so presaging further improvement in the deficit), we should be at least a little more relaxed about the outlook. The explosion in capital flows - both in and out - is surely worthy of much more comment than it has received so far. Time will tell whether it is primarily secular or cyclical. To some extent, one’s answer to this should determine the degree of optimism or pessimism on the outlook for the deficit. Brad feels strongly these flows won’t last. I’m relatively agnostic (although more in the secular camp for reasons that merit another guest post - Brad?) but certainly find to get overly stressed about the financing of a 5.5% of GDP deficit when capital inflows have been running at 18% of GDP.
More generally, I wanted to bring the Cordenite, ‘consenting adults’ view of the deficit to the table. This view of the world by no means claims that deficits do not matter - far from it. But rather it questions whether the current account is the appropriate benchmark for our concerns. Brad is passionate about the current account deficit I presume primarily because he regards it as an effective barometer for future economic stress that may produce painful economic out-turns further down the road.
I used to agree whole heartedly but am no longer so sure. Maybe better to look at the level of finer level of detail at which decisions are made - households/businesses. That is the level at which stress will be experienced.
A couple of comments implied I am taking an unreasonably Panglossian view of the outlook. Not true. I am far from optimistic about the outlook for the US economy at least in the short term. But my main worry remains the unprecedented cashflow deficit of the US household sector and its reliance on continued, and probably unsustainable, asset price inflation to mainatin its financial health. As asset prices fall - particularly if equities head south in tandem with already sliding house prices - household cashflow could adjust sharply with harsh consequences for the economy as a whole. The current account position would then improve rapidly. But as I stressed in my earlier post, my concern is that recession prompts a violent correction in the current account deficit, not a sudden stop in capital inflows tips the economy into recession.
Richard Iley
“…BlackRock chief Larry Fink told investors he was advising clients to begin adding risk to their portfolios and has started positioning the fund manager to take advantage of current market conditions… if there is a recession, it won’t be a long one. And when the market turns, it’s gonna turn very violently… Unfortunately we are just a third of the way through the problem in sub-prime resets, and we’re going to have more problems in the future.” Still, he said, a combination of rising exports driven by a falling dollar, continued investments in US assets by foreign investors and increased awareness of the problem by the federal government should mitigate the severity of a contraction…” http://www.financialnews-us.com/?contentid=2449378941&page=ushome
“The Greenwich Global Hedge Fund Index is up +10.53% year-to-date despite falling -1.61% in November and continues to outpace equities for the month and year. All four equity indices were down by more than 4% in November: the S&P 500, MSCI World Equity, and FTSE 100 Indices posted -4.18% (+6.23% YTD), -4.24% (+7.97% YTD), and -4.30% (+3.41% YTD), respectively…” http://www.businesswire.com/portal/site/google/index.jsp?ndmViewId=news_view&newsId=20071212005282&newsLang=en
‘Canadian’ assets? - “…There’s about $250-billion of credit assets that could end up in a fire sale if the plan fails, which would roil world markets and could force many banks that are holding similar assets into writedowns…” http://www.globeinvestor.com/servlet/story/RTGAM.20071214.wabcp1214/GIStory/
Response to bsetser on 2007-12-14 15:23:46
It would be interesting to relate the current account deficit to some larger domestic macro measures. For example, the Fed’s net household worth measure is now around $ 59 trillion. It’s skyrocketed in the past few years with the increase in equity and real estate values. But it will be interesting to see the upcoming trajectory with falling house prices - or worse with stock market declines as well. NIIP has been small and contained (in the $ (2) trillion area I believe, albeit with data issues) compared to the household net worth increase. Arguably, income and savings data are more indicative than asset value data in terms of predicting the sustainability of the current account deficit. But projections for US consumer expenditure should consider the ‘wealth effect’ and this ends up being relevant for how the current account will adjust. The comparison should indicate something about current account sustainability in terms of asset value consequences. I think NIIP effectively represents the amount of household net worth that has been swapped over time in exchange for the cumulative current account deficit. Moreover, just as the current account deficit can adjust according to different types of outcomes for GDP growth, it should be possible to consider various outcomes for NIIP in the context of corresponding outcomes for household wealth.
Anonymous — I have a hard enough time modeling how the external deficit impacts the net int. investment position with the expansion of gross flows/ increased size of the US external balance sheet/ increased impact of valuation gains. You will have to help me a bit if I am gonna try to include household wealth … what precise connections interest you?
Richard — If you want to continue slumming on a blog rather than writing from high-end clients, a guest post on whether the increase in gross flows is cyclical or secular would indeed be interesting. Especially if you wanted to tackle what role tax and regulatory arbitrage have played in the increase in gross flows. My bet is that tax/ regulatory arbitrage plays a substantial role, and barring a major regulatory change, that may propel a secular increase in flows — but it is basically lending between NY and offshore tax and regulatory havens, including london that doesn’t generate much real financing or lead to a net increase in foreigners real dollar exposure. just a guess tho –
monday’s release though should be interesting since the TIC flow data (and the fed flow of funds) suggest a meaningful deleveraging in some areas — i.e. a big fall in foreigners selling liabilities (ABCP) to Americans to finance the purchase of ABS
Response to bsetser on 2007-12-15 08:48:53
It would be outrageous of me to suggest that household net worth be modelled in parallel with the level of detail you achieve at the international level. I’m not really suggesting any modeling around this aspect. It’s more an observation, although now I’m wondering if it’s a useful or useless observation.
My only point is that the relationship seems to be an asset counterpart to deficit sustainability. After all, unless the scaling effect works forever, there will continue to be a transfer of wealth from the US to surplus nations over time. It seems intuitive that there should be limits to such a transfer of wealth and its proportion to overall wealth. The US is now concerned about a relative trickle of SWF diversification in the context of a $ 2 trillion NIIP and a $ 60 trillion net worth. How will it feel about a situation where the NIIP starts to grow more quickly while net worth is stagnant? It’s been contained so far, but how long can that last? It seems intuitive that high net worth growth and low NIIP growth have correlated with deficit sustainability so far. I’m wondering what happens overall if net worth growth slows down considerably. It wouldn’t surprise me to see the relative growth rates of these invert fairly soon. It’s hard to believe that net worth is a completely unrelated factor. But I’m not suggesting any detailed analysis - just an occasional ‘reality check’, if that’s possible in the context of a rather unreal growth in the deficit itself.
gillies–
Add the following: oil will be inflationary, not only for home and local use, but for imported goods. While wage, tax, and regulatory arbitrage have been deflationary and while printing money and dollar devaluation have been inflationary, energy might well be the key to a lot of things.
Economists tend not to look at peak oil arguments, however you wish to define them. Oil as a resource is simply not infinite. Instead of arguing that sustainable production has peaked or is near peak (and I think it is), I prefer the simpler definition: The tap outflow simply will not keep pace with need. Major developing countries (China, India, etc) are energy hungry. They need that energy not only to continue to build and sustain their export platforms but also to move to more consumer oriented economies. I fail to see how all this is going to happen successfully or happily, even if some aspects of global warming bring relief, i.e, Northwest Passage, Arctic oil. Add to this lethal mix, the depletion in bio-resources and water, a result not only of need and growth but also because of those annoying exongenous variables, pollution and warming.
Account deficits may not be the primary barometer of future economic stress. Iley and Roubini would agree that falling assets prices (homes, etc…credit crunch, toxic loans) may well lead to a consumer tap-out…and a very hard landing indeed.
While it is difficult to tuck all the issues verbally into one equation, I think we are on the brink of a perfect storm, one that will not hit suddenly but will be one wave after another, each more troubling and devasting than the last. Discussion here tends to be very focused, too focused from my view, on narrow economic slices, but that is the consequence of specialization, a form of thinking we may soon no longer be able to afford or one that may well be seeing its last legs. Eventually…and, in my view, sooner than many here think…a more comprehensive integrated view will be essential, inevitable. It already is beginning to occur.
I enjoy Brad and Roubini because they seem to be pushing that envelope, even as they continue to look at the world through the prism of their own respective and considerable expertize. At some point we may well see blogs such as this excellent one bring in not only the likes of Richard Iley but also experts in other slices of the world, slices that have a direct bearing on our overall future. The envelope will expand.
i too appreciate the tolerance and hospitality of the site. a mixture of specialists and
people who take in a broader panorama - is productive of ideas.
industrial growth is derived from energy - most of it fossil fuel. india and china may
have a growing demand for energy, but although industrialisation drives energy
demand, it is itself dependent upon energy supply. in a global economic contraction,
hunger for energy - thus prices of oil and gas - would fall.
in the longer run, contracting energy supplies can mean falling energy prices.
“…may mean contracting prices…” It may be a bit more complicated. I would put emphasis on “may.” As prices rise, energy use may well contract; on the other hand, some resources are indispensible to the maintainence of a standard of living. What if the world can produce oil at a only given quantity per day or year? Maybe, given the size of the “tap,” only a finite number of refineries will be usable? Growth may stall; growth itself may peak.
I’m not an expert, but it seems to me, that the price the US is paying for using the reserve currency role of the dollar for financing the debt hurts not only the debtors abroad, but is partially as well damaging those Americans not working in the finance sector (e.g. by inflation).
A widening of social unequality may at some point lead to stress in some way.
if Richard might be able to elaborate as to how his views may have evolved from this: “…Richard Iley described the American economy as the Titantic - a big ship admired by the rest of world, but potentially running on excessive amounts of fuel and warned of “grave dangers lurking ahead,” in particular, the large amounts of debt incurred by consumers…” http://www.milkeninstitute.org/events/events.taf?function=show&cat=allconf&EventID=GC05&level1=program&level2=agenda&EvID=483
- if he (still?) sees the USD as nothing more than a “consumer-spending driven fiat dollar”
Does anyone know how to make this thread the normal width?
I might read it then!
Reply to guest earlier today and, en passant, some other comments.
Several points:
First, my prime motivation for my post was that, relative to 2-3 years ago, I have become somewhat more relaxed about the propsects for, and implications of, the current account deficit as I think there is a building case that some of the facts have changed. But does this mean that I do not have major concerns about the economic outlook and simply see blue skies ahead? Of course not.
We also need to be careful not to conflate seperate issues. In the speech you cite I was very concerned about what was already (spring 2005) an emerging housing market bubble and so the building risk of a housing market crash that could tip the whole economy into a deep and painful recession. Household balance sheets looked robust but only based on probably unsustainable asset prices. If they fell, net worth risked heading south rapidly (assets down, liabilities unchanged), forcing a rapid, possibly ‘wrenching’ adjustment in the household sector’s freecash position aka the financial deficit, which is the biggest single driver of the record current account deficit. In advance of that risk, there seemed another key risk facing the economy - namely foreigners concerned about the same issue and also the unsustainable trajectory of the deficit/ prospects for a weaker $ could lead to the so-called ’sudden stop’ in capital flows, forcing up rates and in effect catalysing the first risk.
2-3 years on, the terrain looks somewhat different. Few now seriously doubt that the existence of a housing bubble, at least in broad swathes of the country between 2003-2006. And trust me - as a voice in the wilderness on this two years ago, it used to highly controversial! The bubble is of course now in the process of bursting and we are partially through what will probably the worst housing crash since the 1930s. I continue to fret about the household sector freecashflow deficit as noted in my earlier comment and, as the drop in house prices accelerates, the risk of more severe cashflow correction (i.e. rise in the household savings rate) increases.
But despite the accelerating drop in house prices, the jury to some extent remains out on the durability of consumers’ financial health and so the likely scale and speed of cashflow adjustment. The performance of other, ex-housing asset prices remains crucial for how the dynamics of the household balance sheet evolve in the coming quarters. If they, particularly equities continue to rise, the overall net worth position of the household sector may not be too badly affected even if house prices drop c.10-15% on a nationwide basis (for the record - total household assets c.$73trillion o/w residential housing c.$21 trillion & total equity holding c$25. trillion). Note housing net worth fell in Q3 but overall household sector net worth still increased. But if equities level off, let alone fall sharply, at the same time as house prices are falling then household balance sheets will weaken. Equity markets so far have been surprisingly (at least to my mind) resilient. This partly reflects the still impressive strength of overseas earnings, which may or may not last, and account for an increasing share of S&P earnings. Corporates ability to use historically high levels of cash to finance record share buybacks has also been important. By the way, if anyone knows for certain how the stock market will perform next year, please let me know!! The point is that the risks for economic growth, already on course to be weak next year, are skewed heavily to the downside as the housing market bubble continues to burst and the excess supply in the housing market is slowly worked off.
What about the second subsidiary risk? Has the unfolding housing market adjustment been triggered by a spike in interest rates as the financing of the current account deficit became more problematic? No. As I have already written at great length, even as the problems were crystallising, capital, mostly private, has so far continued to flood into the US at a record pace, suggesting that we all largely underestimated the value of the ‘exorbitant privilege’ and the accelerating decline in home bias that has seen gross capital flows, not just in and out of the US but globally, explode in recent years. As also discussed, metrics of sustainability if anything look better than 2-3 years ago and the net investment income balance has stayed stubbornly in the black. And finally, the $ has fallen a long way already without its drop ever looking like becoming a rout. Of course, capital flows into the US may yet ’stop’, the dollar may yet collapse but these seem more clearly tail risks to my mind than they did a few years ago. And the weaker $ (plus falling asset prices) seems already to helping attract some good-size globs of real economy investment. FDI seems to be up in Q4 (big investments in financial services, chemicals, computer gaming etc) and I have lost count of the people back in the UK asking whether it is time to buy a condo in Florida yet! Isn’t the market mechanism working???
Let me put it another way in conclusion. Unusually high asset prices, particularly high house prices, have been the prime cause of the record current account deficit by helping drive national saving to historic lows. Over the next year or so as the ‘tide goes out’ we find out how sustainable current valuations are and so how strong/durable household balance sheets really are. If current levels of household net worth are broadly sustainable, then the deficit and the NIIP position look relatively benign. Net foreign debt of $2.5 trillion vs. household assets of c.$73 trillion aint too shabby (Brad, as an aside, shouldn’t we look at NIIP more relative to the national balance sheet i.e. US total net worth rather than GDP i.e. stock vs. stock??) If assets price deflate sharply, then the short-term economic outlook will be very bleak but at least the current account deficit will adjust sharply. I’m along way from arguing that the current account deficit is simply a benign accounting identity but, as stressed earlier, I remain far from convinced of the case of according it independent policy priority is limited and certainly much weaker than it appeared a few years ago.
Richard Iley
US Household Net Worth Up 1.1% To $58.60 Tln In 3rd Qtr
Thu, Dec 6 2007, 17:00 GMT
http://www.djnewswires.com/eu
US Household Net Worth Up 1.1% To $58.60 Tln In 3rd Qtr
By Jeff Bater
Of DOW JONES NEWSWIRES
WASHINGTON (Dow Jones)–U.S. households’ total net worth rose 1.1% to $58.60 trillion in the third quarter, the Federal Reserve said Thursday.
The Fed’s quarterly “flow of funds” data also showed U.S. nonfinancial debt rose at a 8.9% annual rate July through September.
The 8.9% rate was above the revised 7.2% rate in the second quarter, initially reported as a 7.1% growth rate. The Fed said the acceleration was in the federal government and business sectors, with the household and state and local government sectors showing modest decreases in the rate of debt growth.
Household net worth in the third quarter decreased to about 5.72 times disposable personal income, from a second-quarter level of about 5.74 times income. Household net worth is a measure of total assets, such as houses and pensions, minus total liabilities, such as mortgages and credit card debt.
WASHINGTON (Reuters) - The net wealth of U.S. households rose to $58.60 trillion in the third quarter as financial asset gains outpaced slowing real estate values, a Federal Reserve report on Thursday showed (see chart above).
In the July-September period household net worth grew for the 20th consecutive quarter and established a new record high. The record $58.6 trillion posted in the most recent quarter was up from the second quarter’s $57.98 trillion, the previous record high. Compared to last year, household net worth has increased by $4 trillion, which translates to more than $36,000 of additional net worth per American household.
Household wealth has increased by almost $20 trillion in the last five years, and the average American household now owns about $528,000 worth of stuff (assets, real estate, etc.), free and clear of any debt! In 2002, average household wealth was about $370,000, and today it’s more than half a million dollars. Therefore, in just the last five years we’ve become more than a third richer (+43%), which is truly amazing!
Bottom Line: In spite of $100 oil, $3 gasoline, a weak dollar, and subprime mortgage troubles, Americans are wealthier than ever before, and probably wealthier than any country on the planet, with average household wealth of more than $500,000!
BUT - NOTE - HNW decreased from $ 41 trillion in 2000 to $ 39 trillion in 2002!
DUE FOR A REPEAT?
Response to bsetser on 2007-12-15 08:48:53 and Richard Iley on 2007-12-16 15:02:48
As per data I provided in the last two comments, I think the marked to market risk on net household worth is as plain as the noses on our respective faces.
I think I’m using a combination of Richard’s conceptual approach and Brad’s income based approach to suggest that the risk tilts in favor of Brad’s concerns.
btw, the idea of marked to market risk on net household worth is fundamental to shooting down complaints from many about NIPA savings definition excluding market to market.
Also, as a macro risk factor, this broader household wealth concern starts to remind me of how the entire subprime fiasco was overlooked for so long by so many. Very few are looking at this and we all should be, including in the context of NIIP and current account sustainability.
Yes, a fall in household net worth is a risk — though the resulting cut back in consumption would if nothing else tend to reduce the current account deficit. I share Richard’s basic views about the balance of risks in 2008, especially his concern that deteriorating household balance sheets will crimp consumption and the broader slowdown will eventually end the resilience of equity markets, though I would put a bit more emphasis on external risks (still). The dollar’s fall against European currencies has been orderly — but Europe, in aggregate, hasn’t been the one financing the US. And the losses implicit on the balance sheets of those who are (judging from the size of their current account surpluses) haven’t been realized b/c the dollar’s adjustment against many surplus currencies has yet to really begin!
Richard, I guess I have never really understood the appeal of looking at foreign claims on the US v household assets. Those who make this argument often argue something like “don’t worry, the US still has plenty of assets to sell.” That’s true, but there is no guarantee anyone will want to buy them on current terms. Argentina didn’t run out of domestic assets to sell back in 2001. The domestic banks had tons of GOA bonds that they wanted to sell, but they couldn’t find buyers –
And in some sense it feels like there is a bit of reflexivity in the argument that the increase in household net worth more than makes up for the increase in foreign claims on the US. In the so-far-unrealized scenario Nouriel and I outlined back in 04, a fall in foreign demand for US assets pushes up US rates and pushes down asset values, so there is a correlated shock to the income balance (offsetting some of the improvement in the trade balance) and household net worth.
Finally, I am not as convinced that the increase in gross flows over the past few years represents a fall in home bias rather than the activities of what Bill Gross and now Gillian FT (see tomorrow’s FT) call the shadow banking system.
Moreover, I rather suspect that the q3 data will show something of a sudden stop in (net) capital flows, and some categories of gross flows. The flow of funds data certainly suggest a big fall in foreign demand for US asset backed securities — and a fall in US s-term claims on the rest of the world. That suggests a bit of deleveraging to me.
And when I add up the announced FDI inflows in q4, they still seem way to small to finance what likely will be a closer to $200b than $175b quarterly current account deficit. $8.75b maybe offsets the higher oil import bill …. I suspect the main source of financing in q4 is bond purchases from SAFE, along with a few chinese banks. Same old, same old. Global reserve growth looks to have been very strong in November.
I also take a bit less comfort in the fact that there are no signs of distress in the treasury market, as there are a host of other markets where foreign demand does seem to have dried up (partially offset a rise in interest in some distressed us assets) — the US has lots of external liabilities linked to LIBOR, for example. Agency to Treasury spreads are up I think (not sure how much tho). And there is no demand for certain kinds of ABS at almost any price …
It feels to me like centr