To worry or not to worry – more (sort of) scary graphs
Has the US slowdown, the credit crunch (See Krugman), the resulting fall in the current account deficit and rise in the risk of a recession (Read Summers) reduced the risks associated with the United States’ need to finance its still-large current account deficit?
That is the crux of the recent debate that I had with Richard Iley, a senior economist at BNP Paribas — a debate got rather technical, even by the standards of this blog. But despite some points of agreement – the technical debate did draw out an important difference in how Richard and I view the world.
Richard is impressed by the resilience of US capital flows and the strong recent improvement in the US current account deficit in the absence of a recession; I am more impressed by the fall in private demand for US assets and the resulting increase in US dependence on financing from central banks and sovereign wealth funds.
I tried to reduce everything to a single graph – one that I think explains why the US is turning to the CIC and Abu Dhabi for a little bit of financing ($15b isn’t that large relative to either the US deficit or official asset growth in China and the Gulf) and central banks for a lot more.
All data is presented as a rolling four quarter sum.
The tan area represents the US current account deficit. The yellow area represents US purchases of foreign assets – both outward FDI and long-term portfolio flows. On the assumption (which Richard and I share) that short-term bank flows are not a major source of inflows or outflows, financing, the combined total represents the amount of financing the US needs to attract from the rest of the world. The red line shows long-term inflows – both FDI and portfolio flows – into the US. The gap between the red line and the total yellow area has to be filled by either short-term inflows or by central banks and sovereign funds.
In the late 90s and in early 2000 – back when the dollar was strong even in the face of a fairly large US external deficit – long-term private flows matched the US financing need. That isn’t the case today.
Even if you believe the US data accurately captures real private demand for US assets, the gap between private long-term inflows and the US financing need has gotten bigger, not smaller, over the last year. The increase is US capital outflows has offset the fall in the current account deficit.
The only part of the graph that isn’t straightforward is the blackline. That is an attempt to estimate “true” private demand for US financial assets. The black line is substantially lower than the red line – implying that I think the US data understates central bank and sovereign fund inflows and overstates private inflows. This is for three reasons –
- Purchases through London – which ultimately show up in the survey revisions (the scale of those revisions in 2006 can be seen in a subsequent graph)
- The use of private fund managers, especially by sovereign wealth funds buy increasingly by central banks
- Offshore dollar deposits that are available to finance the purchase of long-term US assets (or to make short-term flows to the US).
* A Technical note: My estimate for real private demand is obtained by subtracting my estimate for total reserve growth from the sum of private purchases of long-term US assets and total official flows. The residual assumed to be "true" private demand.
My estimate of “true” private demand for US assets isn’t perfect. It requires making a lot of assumptions. But using the US official/ private split requires making an even bigger assumption – namely over the last four quarters, a period when central banks and sovereign wealth funds added around $1,200b to their assets, only $350b made its way to the US …
And by this measure, private flows – true private flows – to the US are as low as they ever have been. The gap between what the US needs to cover its deficit and its desired investment in the rest of the world (at current exchange rates) and what private investors are wiling to provide is about 10% of US GDP.
That is huge – and it is why every day it seems like a sovereign funds is buying up a little bit more of the US.
Richard argues that the fact that the US deficit has improved even in the absence of a real crisis – whether a fall off in capital flows or a recession – is remarkable.
I view things somewhat differently. The improvement in the current account deficit reflects what seems to me to be a very real crisis in the credit markets, though one that has taken a very different form than the crisis that Nouriel and I worried about in 2004.
Back then we worried that a collapse in foreign demand for US debt would push up interest rates, triggering a sharp fall in residential investment, a sharp fall in home prices, a credit crunch and a slowdown in US consumption. A lot of this has happened – though not the fall in consumption — just in the reverse order. A fall in home prices and a fall in residential investment have triggered a credit crisis – and that credit crisis has led to a sharp fall in demand for US debt and a more modest fall in the dollar. Home buyers gave out before foreign financiers, but the overall result isn’t all that different, though the adjustment hasn’t been as sharp and pronounced as we feared.
Certainly the collapse in demand for US debt from private investors abroad has been sharp. Consider the quarterly long-term flows data (the gap between the blue line and the green area shows the magnitude of the survey revisions earlier this year):
The fall in demand for US corporate debt (especially from the UK) has been especially sharp.
The sharp fall in total bond inflows line from the preceding two graphs is, of course, a reflection of the fall in total inflows to the US in my scary graph. It is based on the same underlying data. The higher frequency graph – updated for October – isn’t quite as scary as before, but it doesn’t suggest rude health either.
I think this gets at the core difference between Richard and I. Despite the absence of deterioration in the net international investment position (or perhaps because the improvement in the international investment position stems from the poor returns on investment in the US), foreign private investors do not seem substantially more willing to finance the US deficit now than they were back in 2004.
No doubt at some point the US dollar will fall enough (maybe it already did in November?) to induce European investors to buy more US assets – or to induce central banks and sovereign funds who are forced to hold assets offshore and thus must choose between the dollar, euro and pound to opt for even more dollars than they do now. But putting your assets on sale isn’t exactly an ideal adjustment mechanism.
And I don’t yet see much of evidence of a real pickup in private demand for US assets. ADIA and the CIC – which have no choice but to buy dollar-denominates assets of some kind — have been the big investors in US banks (along perhaps with Temasek), not private investors.
The result: enormous growth in central bank reserves, enormous pressure to get higher returns on those reserves, enormous pressure to shift some reserves off the balance sheet of the central bank (China is forcing its state banks to accumulate fx, possibly creating a currency mismatch where none existed before), enormous difficulties sterilizing rapid reserve growth, a rise in inflation in most countries that peg to the dollar and enormous purchases of US assets by state investors.
Setting London aside – and I am still not sure if the UK’s large recorded purchases of US corporate debt (a category that includes “private” mortgage-backed securities) came mostly from central banks covertly seeking yield, Chinese banks seeking yield on the dollars they are forced to hold, Japanese insurance and pension funds seeking yield, European banks borrowing short-term dollars in the offshore market and trying to juice up earnings by buying long-term debt or American banks with offshore SIVs selling commercial paper to money market funds looking for yield and using the proceeds to buy longer-term US debt – financial globalization over the last few quarters has reduces to an enormous flow of private capital to the emerging world and an even more enormous official outflow from the emerging world.
I wouldn’t characterize this as a healthy global system – even if it perhaps can be sustained for a while longer.
Private investors want to finance deficits in countries that don’t want to run deficits. The countries now accumulating reserves the fastest have the least need for reserves. The country with the largest deficit is struggling to attract enough private inflows to match the increased desire of its private sector to buy foreign assets – let alone both the deficit and those outflows. And the country with the strongest traditional aversion to state-ownership is now the country most-reliant on government inflows.
“…Armed with strong balance sheets, acquisition war chests and the prospect of cheap valuations, companies around the globe are still pitching ideas with the hope that they materialise into deals at some time in the new year… corporate buyers should be in the driving seat in 2008, since the financing markets continue to present major hurdles for private equity buyers… financial services deals are more likely to involve capital infusions… as opposed to full takeovers, at least in the US… a major impediment to full takeovers in this environment is that we have never gone through a period where the only option is purchase accounting and there are significant credit problems,” says Mr Cohen. “If you buy a bank and write the loan book to market, even a 5 per cent discount can mean a very substantial capital hit for the acquirer.”… European acquirers, in particular, have in recent months shown an increasing interest in striking deals in the US while asset prices are relatively low…” http://www.ft.com/cms/s/0/e7aa7b94-af66-11dc-880f-0000779fd2ac.html
The Chinese and the Arabs are awash in U.S. cash which is awaiting to be deployed. The excess US Dollar liquidity can’t be spent internally within their nations so it must be recycled back into the Dollar economy, providing the a capital accounts surplus for the US Economy. Under a secret agreement negotiated under Henry Kissinger, the Washington Consensus itself devised the Gulf Arab petrodollar recycling arrangement through US money center banks and Wall Street financial institutions. The reserve currency status of the Dollar, otherwise known as Dollar hegemony, has the indirect side effect of deindustrialization of the US Economy from decades of currency overvaluation, but the narrow economic interests of an elite group of Wall Street bankers has enormously profited from the current Neo-liberalism globalization regime.
“…”The right thing to do is to err on the side of doing too much,” said Summers, who consults for a hedge fund…” http://www.washingtonpost.com/wp-dyn/content/article/2007/12/19/AR2007121902177.html
“…Chinese-born bankers have been a driving force in a growing number of high-profile global agreements…” http://www.iht.com/articles/2005/07/19/business/banker.php#end_main
http://www.iht.com/articles/2007/12/20/business/Chiecon.php
The average Chinese has an economic output worth $1,721 at China’s low market prices. That works out to the buying power of someone consuming $4,091 worth of goods and services valued at the prices of an industrialized economy – a level of consumption that would leave an American struggling in poverty.
The World Bank declared Monday that prices in China were closer to world levels than it had previously assumed. So the bank calculated that the purchasing power parity of China’s economy was closer to the market exchange value than previously thought.
Jeffrey Frankel, the James Harpel professor of capital formation and growth at Harvard University, has been one of the most outspoken advocates of yuan appreciation. He has cited the World Bank’s purchasing-power-parity calculations to justify his position.
He acknowledged in a telephone interview Thursday that the new World Bank figures badly damaged that argument. “I would have to retract that based on these latest numbers,” he said.
DC — Menzie Chinn has looked at how the new Chinese data changes the picture (literally) over on econbrowser, and even on metrics that look at the ration of the nominal exchange rate to the PPP exchange rate post-data revisions (adjusted to reflect that the gap is usually larger for poorer countries), China looks undervalued to me. Not in a “we can prove it statistically” sense but in if you had to bet, it looks to be on the weak side sense. Using conventional balance of payments metrics (the kind used in this post), China looks even more undervalued.
And we don’t know if China and the GCC countries could spend all the $ they are earning exporting (they don’t have to import us monetary policy, so I don’t buy 1/2 of what you post about dollar hegemony — if china doesn’t like the $, they us has made it quite clear that they should really unpeg …) domestically. the gcc countries don’t send checks with the oil revenue to their citizens — they send to the check directly to their wealth funds. and China is taking steps to reign domestic demand (and to increase gov savings) to offset the stimulus from net exports. We don’t know what would happen if china decided to stimulate domestic consumption rather than us consumption, and spend more on a social safety net at home rather than buying up i-banks …
DC — I took down your last comment. It went off in directions that I didn’t think was appropriate, covered old ground and didn’t relate either to the post or to my comment — which emphasized the GCC and China are making sovereign decisions to maintain $ pegs and to run large fiscal surpluses (the GCC)/ restrain domestic demand (China).
While it’s your blog, censorship of my political-economic views is rather inappropriate in any open forum. The GCC nations are not making sovereign economic decisions, but are militarily subservient to decisions made by an elite Washington-Wall Street clique. The Kuwait royal family is a de facto US puppet regime directly dependent on the Blackwater security firm for its physical security backed by over 150,000 US combat troops deployed in the Persian Gulf region. Think clearly Brad. Unless there was enormous financial consquences, why would the Washington Consensus deploy 2 Aircraft carrier battlegroups on constant station at a massive cost of $200 million per day in the Gulf Arab Oil region. Please don’t tell me that the Chinese and Russians are a threat in that region to justify such a massive military presence.
Brad, What’s interesting on your first graph is the apparently strong inverse correlation since 2002 between foreign private inflows and US FDI & Securities outflows. This should make one question the importance of the much-trumpeted secular trend in diminishing home bias, in favor of more mimetic explanations similarly motivating, and impacting private flows. While I don’t doubt the existence of a secular trend (globally) in diminishing home-bias of private flows, I reckon that the volatility around the trend is almost surely larger than the change in the trend itself. If/when the USD finds something like an intermediate-term equilibrium – the ensuing stampede of feedback-motivated flows will generate quite a meaningful counter-trend move in the dollar, particularly in the absence of official sales into such strength. Given that Japan sold nary a dollar on the yen’s decline to 124 this year, it is interesting to contemplate whether the official accumulators of USDs will use such strength as an exit, or let the counter-trend move overshoot to further preserve and prolong mercantile advantage. Food for thought…
Chiang: It’s annoying that you keep defacing these informative posts. Several others are not pleased either with your usual off-topic rants. Not only are you off-topic but you do not even know what you are talking about when you go off-topic.
Saying that Kissinger came up with the Washington Consensus by secret fiat with Middle East oil producers would not pass muster with the wackiest of conspiracy theorists. Tell us, what do liberalization, privatization, and deregulation have to do with some of the world’s most repressive regimes? Your rants make no sense whatsoever.
Furthermore, the Washington Consensus was originally developed in the context of Latin America, not the Middle East. You are of course free to voice your own version of reality which nobody else recognizes, but this is not the place to do so. Make your own blog where you can write whatever pleases you and see if you can find an audience for it instead of annoying so many people here.
I do have some profound doubts about the “secular” fall in home bias, to be honest –
a) i think you can argue that in some emerging markets, home bias has increased — i.e. local private investors are much more inclined to keep assets at home/ in the local currency. Hot money outflows have reversed for say china, and dedollarization of EM financial sectors is a major trend. the outward flows that show up in the global data are sovereign not private.
b) A lot of the flows that give rise to the overall global data seem to be more tax and regulatory arbitrage than any thing else, especially the short-term flows — i.e. a SIV is structured so that it is offshore so its profits are taxed at a low European rate rather than the us rate even if it is selling $ paper to us investors and buying US asset backed securities.
I don’t doubt that there has been some real changes — Japanese private investors do seem to have less home bias, as do Americans (don’t like the depreciating $), but it doesn’t seem to me that a fall in home bias offers a very helpful explanation for the increase in capital flows to the US that has allowed the us to sustain large deficits.
Guest, so please explain to the rest of the world where Saddam Hussein’s “weapons of mass destruction” are? If the United States isn’t in Iraq for the oil, then what is the reason?
Politics and Economics always go hand in hand. The United States has long ago lost its technological-economic hegemony over the rest of the world. The only remaining trump card that the Washington Consensus retains over other rising powers, China and Russia, is military supremacy over the world’s energy reserves in the Middle East. The Pentagon thrust has been into the Middle East, Central Asia, and more recently Africa to retain US global hegemony.
The United States is no more a democracy today than Russia or China. The real power in the US government is retained by an oligarchic Wall Street Goldman Sachs clique that exploits its political and financial power at the expense of the US general population. The members of the cabal include Henry Kissinger, Hank Paulson, Alan Greenspan, Robert Rubin, Larry Summers, and others in both democratic and republican factions.
I do not like taking down comments, but I also hope this thread focuses on the (meaty) issues raised in the actual post — including summers speech at brookings/ whether or not the risks are higher/ lower now that us private outflows have increased but the US current account is heading down? I trust the same quality that emerged in the last two discussions will emerge here.
Chiang.
I read this blog because I think it is worth while to try and understand what Brad is talking about. It is often very difficult for me to fathom, for it’s complex stuff. Still, I think it’s really interesting, and I try to understand as much of it as my limitations will allow me. A lot of people post comments that often help me understand what Brad is trying to say, yet I am aware that much of it will always be beyond my intellect. I will never, ever be able to grasp all the topics, but that’s OK. It doesn’t make me feel dumb or stupid, and I´m actually quite addicted to reading it.
Your comments here are often annoyingly out of place. I don’t mind your views at all, don’t get me wrong, but airing them here seems often so totally out of place. It’s like when you’re trying to listen to good music and somebody keeps shouting in your ear. It’s annoying.
There are plenty of blogs around where people would lap up your stuff. Absolutely! You might even try your own blog, as someone suggested. See how it goes.
Do us a favour, mate. Less of the manic, conspirational-theory-oriented, repetitive posts. Eh?
Brad- I’m not sure if you read Rosenberg over at Merrill, but he had an interesting piece out this morning noting that FDI into the United States has grown at something like 11.5% in the past year. Apparently the weaker dollar is encouraging some euro exporters to set up factories here. So it seems that at some price, private agents are willing to buy US assets.
Brad: You said that the adjustment was not as sharp as you had feared, but it seems to me that we haven’t seen the worst yet. We’re still pretty far from the bottom, aren’t we?
Brad’s analysis demonstrates that a hand full of central banks are maintaining the value of the dollar by buying up lots of them every month. This is clearly very very risky behavior on the part of the central banks. He also shows that this has been going on for 2 or 3 years now, a long time.
Now, only countries whose central banks are answerable to no one can do this kind of thing, and in fact we see that the banks in question are in fact located in Russia, Saudia arabia, Dubai, Kuwait, China and a few other assorted locations. These are countries in which there are no controls or no effective controls on the government or the central bank (same thing).
This means that a) these shenanigans can go on for as long as these banks have dollars and b) that some of DC’s somewhat wild diatribes are not entirely baseless (except when it comes to China which, unlike every country in the Middle East, is not a US puppet regime).
So, pretty much bad news all round I suspect.
Blanche Morgan Stanley Merrill Lynch Bear Stearns du Bois in Streetcar to the men who come to take her to the asylum: “I have always depended on the kindness of strangers.”
“Guest, so please explain to the rest of the world where Saddam Hussein’s “weapons of mass destruction” are? If the United States isn’t in Iraq for the oil, then what is the reason?”
I concur with many of your views, but this one is quite wrong. The US is in Iraq to please the Israel Lobby and Israel which together control our Middle East policy. This is not just my view but that of Mearsheimer and Walt, authors of the seminal recent study on the Lobby. They point out that if the US had wanted more oil from Iraq it would have relaxed the sanctions on Saddam and assisted him in developing Iraq’s oil resources to bring more onto the market. Israel wants people to think oil caused the invasion to deflect guilt from it. Israel regarded Iraq as an “insubordinate” Arab nation that threatened it and goaded the US into neutralizing it. It would like the US to do the same to the other insubordinate Muslim nation, Iran, but can’t quite get the job done.
ADIA and the CIC – which have no choice but to buy dollar-denominated assets of some kind
Is this statement true? And if it is true, why is it true?
The BW2 reserve managers – CBs, SWFs, and other official actors – have to buy dollars to maintain their pegs. But they don’t have to keep these dollars. Either as little pieces of green paper, or as rights to future shipments of little pieces of green paper. We can see easily from the data above that if they were following the same decision algorithms as private investors, their behavior would be different from what it presently is.
The question is: what decision algorithm are the BW2 players following? Why are they following it? And will they continue to follow it in future?
If you know the answer, you can front-run these official actors and profit at their expense. Since they know this and they are by no means dumb, their thinking is best discerned by analyzing their incentives and their actions, not any communication they may issue. Obviously not an unusual situation.
But first, look at the real incentives facing the private saver. The private saver is offered a return of 4.5% per year on a 30-year risk-free dollar bond. Given that crude measures of mature money are rising at 10% a year – at least – any asset whose price can remain roughly proportional to the general quantity of money in the world, even if it produces zero yield, will be worth four times as much as your T-bill at the end of 30 years.
Why go to college? Why stay in night school? This is a recipe for a rabid bull market in anything which is cheap to store and isn’t about to go out of style. If this is “tight money” or “deflation,” Britney Spears is a virgin. If anyone missed Cassandra’s inflationary maxims, perhaps they should refresh their memory.
And what is the source of this unprecedented monetary hemorrhage? The BW2 reserve managers. While they are aided and abetted by the fractional-reserve magic of “term transformation,” which converts private demand for 2008 dollars into banker demand for 2038 dollars, this machine (as we’ve seen) can lock up or go into reverse at the drop of a hat.
If the BW2 enablers were to stop buying and long-term rates were to go to the moon, the assets behind many securities that are used to back 2008 dollars would drop prodigiously in price. If you think we have an insolvency problem now…
Therefore, the facts in the case are as follows: if we consider the BW2 reserve managers as motivated by the normal motivations of a private investor, ie to maximize yield at term subject to risk, their actions make no sense at all, and we can expect them to stop.
Whereas if we consider them as motivated by the normal motivations of an official investor, ie to minimize political pain, their actions make perfect sense, and we can expect them to continue. Is there anyone right now, in any position of public responsibility, anywhere in the world, who hopes and prays for an increase in long-term dollar interest rates?
My hypothesis therefore is that the CBs and SWFs are acting as responsible managers of the global financial system. In particular, it is interesting to note the correlation between what the BW2 reserve managers are doing, and what the Fed wishes it could do.
For example, the SWFs are recapitalizing US banks. The Fed wishes it could recapitalize US banks. The CBs are buying out on the curve. The Fed wishes it could buy out on the curve.
I mean, if Congress one day woke up and passed a bill that allowed the Fed to do all the stuff that CIC, Temasek, Abu Dhabi or whoever are doing, would anyone at the Fed say, “nah, we don’t need any more statutory authority. In fact, we have all the statutory authority we need and then some. Really, in a financial crisis situation such as today, what we need is less authority, so maybe you should be taking some of our powers away. Where’s Ron Paul when ya need him?”
Of course, the difference between “acting as responsible managers of the global economy” and “doing the Fed’s dirty work” may depend on your positioning.
The real problem is that, in a world in which some regions have a healthy industrial sector and others remain stagnant swamps of 20th-century socialism, no quantity of monetary cocaine, ie officially-orchestrated lending, is right for everyone. Even in the presence of ridiculously easy money, as described above, the US can barely keep its head above water. Whereas the exact same stimulus is almost enough to put Shanghai into orbit.
I really have trouble understanding those who believe that China, at least, cannot “decouple,” or that it will catch the flu if the US catches a cold. Hasn’t it decoupled already? Doesn’t the fact that US monetary authorities are desperately trying to restart their lending engine, whereas Chinese authorities are desperately trying to cool theirs down, tell you something?
And surely, for Chinese exporters, a 5% rise in the yuan and a 5% deflation in US sales have the same effect. Anyone who believes the former would be a good policy for China must believe it can survive the latter as well. This is too obvious – what am I missing here?
“ADIA and the CIC – which have no choice but to buy dollar-denominated assets of some kind- is this statement true? And if it is true, why is it true? ”
They’re not following the same decision algorithms – starting with buying dollars. Why would anybody sell everything they bought? There’s lots of front running. That’s expected when intervening in otherwise free markets. Why expect correlation in the quantity of 0-risk money with the value of non-money risky assets? SWFs don’t print new US dollars. That’s why the Fed should be fine with it. The Fed monetary base has been flat for years. China’s has erupted. Deflation in US sales is precisely the intention in desired RMB appreciation.
Normansdog,
Russia is as well by far not an US puppet.
I assume the real reason why Russia is buying dollars is, because if the rubel gets too high they will only sell energy. This is not good for any economy.
Indeed Russia is pegged to a basket of $ and Euro.
One day the oil in Russia will be sold and this will be much faster than e.g. in SA. Then the rubel will probably fall against the dollar and therefore for Russia it might even be not a similar bad decision to buy dollars than for other people.
By the way, I can’t see, why the financing of their debt through ME oil should be bad for US citizens. They get cheap credit and the others a lousy investment. In case of a serious conflict the US can threaten just not to repay any debt, which can be a more serious weapon one day than tanks.
I think more in the line of jin, that for China it is even a bad idea to buy US corporations. Brad is afraid of lobbying in the US by Chinese Gov. But it may be as well, that some corportions are excluded from some deals, because they are owned by a foreign Gov.
“If I owe U 10,000$ U have me on toast, if I owe U 10 billion $ I have U on toast.”
Brad: “China is forcing its state banks to accumulate fx, possibly creating a currency mismatch where none existed before”,
Intriguing idea; could you elaborate?
Brad wrote: “(they don’t have to import us monetary policy, so I don’t buy 1/2 of what you post about dollar hegemony — if china doesn’t like the $, they us has made it quite clear that they should really unpeg …) ”
They do have to import monetary policy, as the world does, at least for the time being. If everyone in the world uses green paper (especially to buy oil), then you need to have green paper in your reserves.
To quote Ron Paul in a speech to the House of Representatives entitled “The End of Dollar Hegemony”:
“Realizing the world was embarking on something new and mind-boggling, elite money managers, with especially strong support from U.S. authorities, struck an agreement with OPEC to price oil in U.S. dollars exclusively for all worldwide transactions. This gave the dollar a special place among world currencies and in essence ‘backed’ the dollar with oil.”
The more dollars a country has accumulated in the past, the tighter it is bound to the dollar- China depegging will mean its reserves immediately lose value, and its own currency is immediately destabilized leading to social unrest. A country can only slowly diversify away from dollars (and hope others who produce oil do also). A country cannot just drop dollar dependency once it has been “hooked.”
Brad, since you have an interest in China and the trade deficit with the US, read up on the massive British trade deficit with China 150 years ago (tea, silk, porcelain versus silver) and how the British rectified that situation.
DC — I took down your last comment.
Yay! Complaining about “censorship” is the last refuge of the troll.
Dave, you have a strong set of opinions that are just largely off-topic here. Start your own blog (or focus more on it, if you already have one), and I think you’ll be a lot happier.
Brad: I’ve gone back and read your previous post/setser/233036/ as well as this one, and first wanted to say that you’ve put together some excellent (IMO) and much appreciated work. The long term BEA chart (1980 – 2007) in particlar, is very, very illuminating. It’s a fitting culmination to your argument and sums up all the data points rather nicely.
Some (well, actually a lot of) comments:
- When Richard suggests that we’ve adjusted without any significant “crisis”, I have to disagree with his emphasis. Clearly the recent depreciation of the dollar is the reason for the diminution (beyond other fluctuations like slowing domestic demand) in the CA deficit. The depreciation of the dollar is just another way of stating inflation. And inflation distorts; it distorts prices, investments, asset allocations, factors of production, market psychology, socio-economic decision making, etc. It leads to equilibriums that are not optimal. From an economic p.o.v. this is inefficient and bad.
The slow relative decline of the dollar may not be a crisis, but if it brings in its wake new long term equilibriums (such as lower purchasing power for US workers, capital inadequacies, etc.) — it could lead to a crisis, or if not, then just undesirable results.
- Richard argues that the gross is important and that the private outflows could be re-directed if necessary and can be considered a possible “safety-valve”. But this seems like a circular argument to me. Re-directing these funds domestically begs the question: Why? Wouldn’t domestic investment need to become more appealing in relative terms first? *This seems to me like the crux of the whole debate.*
Is the US becoming, or could it become, a less appealing place (relative to others) to invest capital in, long term? Is the US having problems attracting capital? Does the US have adequate domestic capital creation capacity for sustainable long term investment and growth, or do we need foreign capital more? How will the US retain it’s attraction in order to get foreign funding if it needs it? What will be the consequences of policies designed to maintain inflows?
- Net flows clearly have more meaning to the above questions and Brad’s right to point out that the trend in *the share* of CA deficit financing shows that private interest has tapered off while the net official share has increased relative to the net private share. (And that’s leaving out the “adjusted” official flows due to SWFs, ADIA, diffuse private managers, etc.) Yes, as Richard points out, the net private share to GDP is up somewhat, but it has stabilized over the last few years while the net official share has noticably graded upwards and is now roughly equal to it.
We know that higher nominal interest rates, wartime safe haven status and trade finance requirements were blowing a wind in the dollar’s favor. But look what happened when interest rates were cut by less than 100 bps! I think one reason official inflows continue is to perpetuate policy, as Brad points out. The GCC and China and Russia would apparently like to keep their surpluses as they seem to feel the benefits of having a ready export market and inflowing dollars still outweigh the negatives of dollar denominated assets. I think official inflows will continue apace.
- So, if this is really a trend, then one key may be to look at the roughly 1990 -1998 period when net private inflows were also low and net official inflows were higher. The recession at the beginning of that period dampened US domestic demand and imports and led to the last time the US recorded a CA balance or surplus (The 2001 recession famously didn’t).
But at that time, the US didn’t have as much accumulated external and domestic debt, it had a stronger fiscal position (eventhough gdp relative, it was higher maybe, but the post-recession Clinton years would see progessively lower deficits) because Gulf War 1 was much less costly and even funded externally, entitlement programs and unfunded liabilities weren’t where they are now (time factor wise), household debt ratios were lower, etc. So it could be argued that given the last recession performance, the US consumer and private demand is more dependent on foreign inflows now than then. Will any of this have an effect?
- Richard points out that Tobin was worried about net investment income back in 1987. It’s a good point. Four things: 1) I don’t know, but I wonder if net income, while maybe staying positive in aggregate, has dropped since then in *gdp terms*? 2) Going from the world’s largest nominal net creditor to the world’s largest nominal net debtor (in the 80s – twenty plus years ago) seems to me to offset some of the comfort the US should take in still having a positive net investment income position. Why? Because if the undertaken debt had been productively used, then why are we having this discussion today? 3) Being in a large debtor’s or creditor’s position can be dangerous if both foreign and domestic economic conditions go south, so China, GCC, Russia, Brazil, Switzerland and Germany might want to reconsider. Large imbalances aren’t generally healthy, whether + or -. Rather, they’re symptoms of some sort of inefficency if they’re chronic. 4) Assume then in fairness that we consider America’s large post WW1 and WW2 surpluses as “chronically large imbalances” or say, “anamolies”, that are being corrected by a long period of deficits — do we know where we are on that kind of accounting? Have we corrected the imbalance (so to speak)?
- Richard says the twin deficits matter has been punted (paraphrasing). But I think it’s necessary to point out that they are related even if not in the way originally argued by fellow economists. The trade and CA deficit and the fiscal deficit may not be a reciprocating mechanism, but they are on the same chasis and are affected by an underlying drive.
US economic policy is intentionally designed to run trade deficits since imports from American companies operating overseas are not targeted for equalizing measures. Since capital is mobile and transportation costs recoverable, it’s profitable to conduct wage and production arbitrage, privatize the company profits and socialize the costs (on the US national accounts). This benefits the highest concentration capital holders the most, as do the significantly lower marginal tax rates implemented since Reagan. And the all-too-often overlooked Kennedy Round of tariff reductions is (IMO)what preceeded US trade deficits (after accounting for a lag). America’s CA deficit is an intentional transfer of wealth, as is it’s budget deficit. No accident in 30+ years of deficits.
- In general, I still think we shouldn’t miss the forest for the trees. While the technical matter of financing the deficit bears careful consideration, we shouldn’t forget that it’s the financing of the *accumulated* deficits (i.e. net external debt) that we ultimately need to consider. Why are we running these deficits and what future stream of income or return on investments is the US preparing to receive which will allow the US to pay back its creditors in such a manner, and have enough left over in profits, that it improves the general welfare of its citizens (or those obligated to pay back the debt)?
If you lend me $10,000 and I go and purchase and consume 1000 barrels of eggnog
with it, how and with what am I going to pay you back the 10,000 + x (interest) dollars? But if I use that $10,000 to manufacture a widget machine and sell the widgets for $15,000, well, then yes, it’s probably going to be worth it.
I understand that Richard isn’t making an absolute argument and that he sees long term that there are issues either way. He makes a good argument that the financing situation may not be a cause to be concerned with as much as Brad (and NR?) may be. However, with due respect to Richard, I’m in agreement with what Brad has detailed and concluded so far. A great discussion by both of you. Thanks!
Finally, I apologise for coming in late to the discussion and not providing input and encouragement earlier. Been very busy lately. Happy holidays to all!
there is a far question as to whether ADIA is effectively required to buy $ (in order to avoid putting more pressure on the UAE’s dollar peg by pushing the $ down) or whether the $ buying is done by the central bank of the UAE, but trust me, the UAE’s dollar holdings are going up significantly. Rachel Ziemba and i have a new paper out on this (on the RGE site).
Qingdao — you can look back at my old post on China’s missing reserves, or look at Michael Pettis’ blog. Basically it seems like China is requiring the banks to meet their reserve requirement in dollars. the result is that formal reserve growth has slowed — and the banks’ dollar holdings is rising. I’ll have a full post on this soonish …
Funny, regarding private flows, perhaps the worst is not over in subprime and private investors will be buying US assets on the cheap similar to EU investora mentioned earlier. Recently someone approached me and we discussed overall trends. They were interested in cashing out of heady real estate markets, had already started to cash out of heady stock markets, and were concerned to stave off the loss in gold profits they have made over the last few years. Their proposal was to buy cheap American real estate. Real estate signifigantly cheaper than a nation with a per capita GDP, even at PPP, but 6 or 7 % of US standards. Interesting, my the big investor be talking down US assets, might small investors take their few millions and run to cheap US assets. I suspect some of that may be happening. Becaue people know that asset valuations in their dollar pegged economies are probably in worse shape than US assets where the run up in their local valuations are not based in economic soundness.
Face it the dollar peggers, are those who benefit, from many ways, from dollar hegemony, DC…
Your hatred blinds you’re analysis and I still think you are not who you say you are, most likely not even Chinese.
Brad you edited me before, but as I said, holed up in Idaho, decrying the New World Order, where you humored him, you only encouraged the baseless dialogue of his hateful, paranoid, mantra.
Flotsam and Jetsam from the China Daily board, see hime spot his hate there under US-China relations, you will see that the writing style, conjecture is the same, if more tame on this board.
“I’ll have a full post on this soonish … ”
Should be interesting.
DC: you went way too far with your “off topic” posts here. Never try and refute Brad.
DC….
I should remind you of a Russia that is shrinking
A China that as of yet hasn’t meaningfully started to consider caring for hundreds of millions jettisoned from SOE supports, one demographic of the overall population that will be larger than the 400 million that the US is projected to grow to in less than 27 years. A population on the strapped back of the one child policy.
China has to do it now, as it will to burdened in the future.
All three are linked to need for collective response to fundamentailist movements, despite whether you do not find much of that information which you like to mention in your constant scanning of the news media to secure any findings that might support whatever random point you might be trying to shove down everyone’s throat, go away, your cries have gone unyielded for years now, or have you forgotten that,….remember $USD 2,000 gold, would even suffice the gold dinari of the GCC.
One solution to DC, and other media posters, simply skip over their links and cuts and pastes and never respond to any of their points, they will wither as ignored. MOst likely they will pretend to be other people, Cassandras and the like, to move discussion on to their posts.
Stick to Brads, and on topic posts and ignore the DC’s of this world, and others he would pretend to be….simple
Guest on 2007-12-22 01:01:16 – but as you demonstrate, it doesn’t work.
Brad is not censoring – he is editing out trashy, repetitive material – not quite enough in the comments section of this post…
brad – for a guy that spends all of his time worrying about transparency and where the money comes from, along with the influence that comes with it, I do find it astonishing that you are so defensive about attempts to understand the capital flows which sustain Setser/RGE and the influence that comes with that. You are clearly still ‘there’ – and as it seemed to be important to you to stress the point that you’d ‘left’ when you haven’t – i can’t be the only one who finds this extremely odd.
So I’d also have a lot less trouble with the references to Summers if we knew something about his relationship with D.E. Shaw. It sounds like a fascinating firm given what very little we know about it, but for those of us trying to sort through the spin, it would help to know more about where it comes from, the incentives attached, and where it may be trying to go.
Shouldn’t commentators, educators and policy advisors be required to clearly disclose what and whom has the greatest influence, if not controlling interest, in the views they express and the input they request?
Warning – this ends with a very complicated question about international dollar flows, which may or may not make sense. Perhaps you can tell me if I’m onto something, or simply barking up the wrong tree. If it makes no sense, I’ll take it as a strong signal that I should retire to wrapping presents.
“My estimate for real private demand is obtained by subtracting my estimate for total reserve growth from the sum of private purchases of long-term US assets and total official flows. The residual assumed to be “true” private demand.”
Rearranging your implied equation:
Reserve growth = official flows + (LT – LT*)
Where:
Reserve growth = your estimate of central bank reserve accumulation
Official flows = TIC etc. version of central bank inflow
(LT – LT*) = your estimated official flow adjustment for over-reporting of long term private flows LT
Meaning:
Reserve growth = (official flows)*
Where your estimate of central bank reserve accumulation is the proxy for the true level of official flows into the US
This seems like a more direct representation of your methodology, unless I’ve misinterpreted your adjustments at the outset. One adjustment you identify is that where central banks are accumulating dollar claims that are issued by foreign entities rather than by the US – e.g. foreign bank dollar deposits – “Offshore dollar deposits that are available to finance the purchase of long-term US assets (or to make short-term flows to the US).”
This is an interesting assumption. I think it implies that any net dollar financing provided by central banks to the global system amounts to net financing provided to the US. Perhaps this is correct, but it seems like a very broad statement in terms of connecting up international flows.
Moreover, it seems to suggest even broader implications. If it works for central banks, why wouldn’t it work for all flows? Why couldn’t we also conclude that that totality of net dollar financing provided by the world amounts to net financing provided to the US?
It is of course easy to imagine intermediate steps in the process where offshore dollar deposits are not immediately available as capital inflows into the US. Suppose China holds a LIBOR deposit with an international bank that in turn is funding a LIBOR loan to a manufacturing company in Europe. That particular connection doesn’t produce an immediate capital inflow into the US, although one might assume this is the case at a second or later step.
Nevertheless, there is something troubling about the assumption that central bank dollar reserve accumulation amounts to a net dollar inflow into the US, or that the same assumption should hold for broader foreign dollar asset accumulation.
Here’s where my question gets complicated (and I am quite unsure about this). Should one take into account the fact that any country can run a current account deficit or surplus in dollar invoiced and paid products, and that balancing these accounts requires an offsetting capital account surplus or deficit in dollar denominated financial claims?
In other words, is there is a global distribution of national current account surpluses and deficits in dollars, such that the US current account deficit does not account for the entire global (gross) current account deficit in dollars? (I’m aware that the US accounts for most of the deficit side for global current account imbalances, but perhaps the question is more complicated for dollar denominated current account imbalances.) If so, doesn’t this complicate the assumption that foreign bank dollar reserve accumulation amounts to a net inflow of dollars into the US? (Again, the question is so awkward, I’m not certain it makes sense.)
Even if the question makes sense, perhaps its materiality is limited in the context of official flows. I don’t know, but I suspect you do.
Written by Guest on 2007-12-22 06:04:18
But as you demonstrate….
What doesn’t work, you could have skipped over?
But then agreed it is some sort of sport, at a much lower level then the useful discussion that goes on here.
Frankly, I think the world financial system is a Ponzi scheme which has, perhaps, benefited some more than others but in many ways has been a sheer gift of blind faith magic.
Further I believe the “system” and all other such “systems” are inevitably baseless, are inevitabily flawed but very useful for managing the current set of complex human interactions.
Gold lasted a while for contriving the imagined consensus to a system of rewards that enables world trade.
An escalation of consumption and productive use of geographically dispersed factor endowments only made realized by blind faith in various pieces of paper and numbers on a computer screen. Less medicine, increased suffering, less goods, a lessor life? A changed life no doubt without it, but life existed, and human societies thrived outside the present era of prolific production and consumption.
Regardless, all systems are based in faith. Would any real to abrupt transition to another system, lay that fact bare? What would result? Less advanced Digital cameras thus depriving humans of the special moments in life the mind was programmed to record anyway?
Frankly the sheer irrationaility of those papers and numbers seems to me, to be why most seem so intent to maintain, central acotrs that is.
To maintain a system that is groundless while accepting losses on “asset valuations” in a system that continues to build real bridges, roads, hospitals, and schools. I find it a puzzling dilemna where there seems very little of substance in any of it, other than the bridges or plastic bowls it creates.
“I do find it astonishing that you are so defensive about attempts to understand the capital flows which sustain Setser/RGE and the influence that comes with that. You are clearly still ‘there’ – and as it seemed to be important to you to stress the point that you’d ‘left’ when you haven’t – i can’t be the only one who finds this extremely odd.
Brad, please elaborate.
What I personally don’t understand is that the US is on the verge of, or is in, recession as a direct results of liar loans, SIV’s, CDO’s squared, Klios, etc., i.e. as a direct results of opaque, nontransparent, undemocratic, probably illegal, Ponzi-like dealings on Wall Street. Furthermore, CDO’s were sold to the Japanese, they were sold to the Singaporeans, they were sold to the Chinese and Taiwanese, they were sold to the Australians. All these non-US banks are now sitting on tremendous losses.
Brad, I assure you that noone on this side of the Pacific, especially the shareholders who lost on these American CDO’s, are going to be sympathetic to an American who wants to talk about greater transparency of any SWF.
It would be useful to note that this blog is a useful tool where people hash out their understanding of the issues.
Neither does Brad have to respond to baseless accusations, but you don’t have to turn to him for your understanding.
Why else would you beleive it otherwise?
And not all on this side of the Pacific, the same side you imply, see as you
Guest: your criticism of opaque and non-transparent relationships that led to the creation of CDOs that were sold to folks who didn’t understand their risks is one that i share. You could add to the list a veneer of technological sophistication/ financial wizardry that too many people took on faith. I have not been impressed with the reforms that the US has proposed in response — all the talk is about the risk of regulatory over-response, to me the risk is that the US doesn’t do enough to restore confidence in the integrity of parts of our market.
The clearest conflict of interest came with the rating agencies, but there were also incentive problems in a originate and distribute but do not hold model (tho it turns out us banks were holding a bit more housing market risk than they let on .. )
that said I don’t see how turning to institutions with a reputation for actively resisting transparency for an emergecy capital infusion makes things better.
Anonymous 1 — your question is a good one. your rearrangement is accurate; i am effectively using my estimate of $ reserve growth as a proxy for official financing of the US, and then the difference between total long-term flows and $ reserve growth as a measure of private flows.
the key question is whether offshore $ deposits are used to finance the US rather than to finance $ denominated lending to say European companies or emerging economy governments. My operating hypothesis — and it is a hypothesis – is that most ultimately to end up financing claims on the US (largely b/c on us borrowers can take on $ liabilities without incurring a currency mismatch.
i think this is likely accurate for two reasons:
a) European firms generally do not want $ liabilities b/c their revenues are in euros and the like, and they would rather avoid the currency mismatch. if there are a bunch of large european companies funding themselves in $ (for their non-US operations) let me know.
b) I would assume japanese firms fund themselves in yen; everyone else does
c)emerging economies have been “dedollarizing’ — i.e. emerging market sovereign borrowers are reducing their outstanding $ denominated debt in a big way, and in general, more and more borrowers in the emerging world now fund themselves in local currency.
So I cannot find any obvious counterparties outside the US issuing $ denominated liabilities that the banks with $ deposits could be buying on a sufficient scale (think $100b a year) to match the $ deposits in the offhsore banking system.
but that is is an assumption.
for the question on current account balances — if say argentina was back in the 90s and running a large current account deficit financed selling $ denominated claims to the rest of the world, i could see the argument. but right now i cannot identify the other country with a large current account deficit that finances itself by selling $ denominated claims. Eastern europe finances its deficits in euros. Australia in Aussie $. Even Iceland finances its deficit in Icelandic koruna.
there is a sense tho in which there is a combined current account deficit of the $ zone — the US, the Gulf, china, Malaysia, a few others, and that combined deficit is smaller than the US deficit (and falling faster, since the surplus of the Gulf and China is rising). however, the financial flows that sustain the deficit inside the $ zone are coming from the official sector — whether Chinese flows to the US or Gulf flows to the US.
hope this helps.
“that said I don’t see how turning to institutions with a reputation for actively resisting transparency for an emergecy capital infusion makes things better. ”
Noone sane wants to have to deal with nontransparent organizations- nontransparency can and often does lead to abuse. As long as everyone, regardless of country or race, is held to the same standards of accountability, I can’t argue with that, be it SWF or Wall Street.
How we get there will be a big debate (e.g. there are certainly degrees of transparency/disclosure). And I do worry about DC getting censored. But its late here in Asia Pac and I’ve got to go to bed….
I have to say that the discussion on this thread has been a bit disappointing compared to the highs earlier this week; technical posts on global capital flows do not seem to produce a productive discussion. There are some notable exceptions — some high quality comments — but there are a lot that are a mix of anonymous complaints about one non-anonymous poster and a complain about my lack of a transparency/ questions about my integrity from an anonymous poster. Not exactly the holiday spirit.
I have tried ignoring off-topic posts. On very rare occasions I take them down. I would rather they just stop — comments are better when they respond to my post rather than reflect the personal interests of individual commentators.
As for RGE, its board can be found in the about us section of the website. The section needs updating (Mohammed El-Erian isn’t at HMC and my bio hasn’t been updated — i’ll fix that). I am sure the sales staff would be more than happy to brag about its client base if you give them a call — it is a mix of large financial institutions and governments. I am no longer paid my RGE, so my blog is in a sense no different than the latam and European blogs, which also are hosted by RGE but contain the views of people based elswhere. that tho is a bit inaccurate since I have a (small) equity stake in RGE from my work there. but the main reason my blog still appears on the RGE site is that the CFR isn’t yet ready to host it (technically, and the required decisions haven’t been made). that is about as transparent as i can be.
I worked fairly closely with Summers, Geithner, Truman, Lipton and Atkinson (to name the political appointees) on emerging market crises in the 1990s, with Sobel and Radelet (to name the career staff) and with Quarles and Forbes (less so Taylor) in the Bush Administration. I also know Tim Adams from that time. it is safe to assume am in contact with some or all of them tho to various degrees– and pay particular attention to the views they express. Summers has in the past cited my work on reserves, so i clearly am in contact with him. The views i express on this blog are entirely my own.
I also have consulted/ consult for various financial institutions. The work I do for them doesn’t appear on this blog. I also occasionally get paid to talk on specific topics.
The views I express here tho are entirely my own — not those of RGE, Nouriel Roubini, anyone who has invested in RGE, the CFR, any of the members of the CFR or anyone who has hired me. I suspect many strongly disagree with my very strong view that the current practice of taxing carried interest at the capital gains tax rate is unjustifiable; many also disagree with my views on sov. wealth funds.
Now hopefully I’ll develop a bit more holiday spirit.
Parse this, you evil economic voodoopeople: In the case of S&P, assessments of the credits insured by FSA are reflected in defined “capital charges,” which are reduced by reinsurance and collateral to the extent “credit” is allowed for such reinsurance and collateral. Credit provided for reinsurance under the S&P capital adequacy model is generally a function of the S&P rating of the reinsurer and the qualification of the reinsurer as a “monoline” or “multi-line” company, as well as any collateral provided by the reinsurer. Capital charges on outstanding insured transactions and reinsurer ratings are subject to change by S&P at any time. The downgrade of a reinsurer by S&P from the Triple-A to the Double-A category results in a decline in the credit allowed for reinsurance by S&P from 100% or 95% to 70% or 65%, while a downgrade to the Single-A category results in 50% or 45% credit under present criteria. A downgrade by S&P of FSA’s reinsurers would reduce the “margin of safety” by which FSA would survive a theoretical catastrophic depression modeled by S&P. A reduction by S&P in credit for reinsurance used by FSA would also be expected ultimately to reduce the Company’s return on equity to the extent that ceding commissions paid to FSA by such reinsurers were not increased to compensate for such reduction. FSA employs considerable reinsurance in its business to manage its single-risk exposures on insured credits. Any material increase in capital charges by S&P on FSA’s insured portfolio would likewise be expected to have an adverse effect on FSA’s margin of safety under the S&P capital adequacy model and, ultimately, the Company’s return on equity. The Company may seek to raise additional capital to replenish capital eliminated by any of the rating agencies in their assessment of FSA’s capital adequacy.
Why expect correlation in the quantity of 0-risk money with the value of non-money risky assets?
Because you don’t really mean the “value” of these assets. You mean their price in 0-risk money. The more 0-risk money, the higher buyers can afford to bid.
SWFs don’t print new US dollars. That’s why the Fed should be fine with it. The Fed monetary base has been flat for years. China’s has erupted.
Measuring zero-maturity money is an tricky task in a financial system that can transform maturities, but I find “flat” a strong description of this curve. Of course your point that China’s eruption exceeds it is true.
SWFs do not print anything. BW2 CBs print new instruments whose exchange rate to the dollar is fixed and drifting upward.
Imagine a world in which the Fed actually authorized the PBoC to issue its own dollars. Instead of printing yuan to buy dollars, it could print dollars – identical to the American bills, except for a small “made in China” stamp – to buy dollars. Instead of the PBoC defending the peg, Congress could simply make these China dollars legal tender.
If we disregard any crawl in the peg and assume it is fixed permanently for good, dollarizing China does not change the behavior of any economic actor. But it also shows us a bizarre reality in which dollars are being printed to buy dollar bonds. (Or, at least, this reality is economically bizarre. Historically it is actually quite common.)
It is interesting to compare the monetary strains in this dollar-zone to similar strains in the eurozone. The relationship between China and the US, for example, has some resemblance to the relationship between Germany and Spain. Goldilocks for one is boiling the other. If this isn’t “decoupling,” what is it?
The monetary base is not the same as MZM. The Fed prints the monetary base. It does not itself print MZM. The monetary base has been flat. The Austrian criticism of fractional reserve banking also falls flat on this front, given the parallel flat profile of domestic bank ‘fractional reserves’.
Dollarizing and pegging are very different. The Fed and Congress don’t in fact sponsor the Chinese currency. So China’s money supply is quite separate in terms of gauging its direct effect on US inflation. China is not printing money to buy bonds. It is printing money precisely because its private sector won’t buy bonds. The money it prints is used for anything but buying bonds. That’s why it’s inflationary to the Chinese economy. The domestic Chinese monetary effect of maintaining the peg channels unique inflationary impulses into the domestic Chinese economy, away from the US, while channelling opposite disinflationary impulses into the US economy. Dollars are not being printed in China to buy US bonds – the dollars that buy bonds are sourced from the US – with 0 Chinese involvement in the dollar printing press.
“Imagine a world in which the Fed actually authorized the PBoC to issue its own dollars. Instead of printing yuan to buy dollars, it could print dollars – identical to the American bills, except for a small “made in China” stamp – to buy dollars. Instead of the PBoC defending the peg, Congress could simply make these China dollars legal tender. ”
that is a very useful exercise. but imagine a world in which each country or currency block printed two currencies – the local currency unilaterally, and the reserve currency by global agreement.
or suppose the chinese issued pegged yuan, say ‘yuandollars’, and also appreciating / depreciating yuan. how would it work, and under what policy regime, and if it couldn’t work – why not ?
.
Did I say “monetary base” (M0)? I don’t think so, but in any case I meant MZM. I should have been more precise.
Not that MZM is a terribly good indicator either. There is no qualitative line to be drawn between money of zero maturity, money of one-hour maturity, money of 30-day maturity, etc. In fact, in a world where short-maturity liabilities can be backed by long-maturity assets, it’s arguable that maturity of dollar claims is irrelevant. The assumption that maturity transformation is limited to traditional checking-deposit structures is also, obviously, inoperative. The point is just that the number of claims to dollars is increasing at a fairly considerable clip, and this number is certainly not limited in any way by M0.
I disagree with you about pegging versus dollarization. Some exporter makes a knicknack and sells it to the US for $1. The PBoC prints 7.5 yuan to buy the $1, then uses the $1 to buy a US bond, returning the marbles as Rueff used to say. The 7.5 yuan are spent on noodles.
Clearly if the 7.5 yuan was one renminbuck or RM$, with a 1:1 peg, this would just be a renaming and redenomination of the currency. My point is that, if the Fed accepted RM$ to buy Treasury bonds, and the noodle vendor accepted US$ to buy noodles, we could duplicate the same transaction as:
PBoC issues one RM$ to buy Treasury bonds.
Vendor spends one US$ on noodles.
So these transactions are completely delinked, and we see the net effect of the transaction: the PBoC has created one new RM$ to buy Treasury bonds. Ergo, if the PBoC ever decides to stop with this, the Fed can maintain continuity by picking up where it left off.
My point is that if the peg was a perfect peg, ignoring crawls, capital controls, etc, the US and China would by definition be a single currency area. Call its currency the PD, Pacific dollar. Within this area, you would see large numbers of PDs printed in China and lent to the US.
In this case, does it matter at all where the PD printer is? Not at all. The PDs first appear in the hands of the US borrowers. We see more dramatic rises in consumer prices in China not because the PDs are being printed there, but because they are ending up there. They are ending up there because China’s productive economy is healthy and expanding, and the US’s is a massive rustbucket. If it was the Fed, not the PBoC, which printed PDs and exchanged them for reserves, the new PDs would still be spent on the same Chinese knicknacks and end up in China.
So in a sense, yes, the US is “exporting inflation” and China is importing it. But this loop happens because China, by plugging itself into the USD at an undervalued rate, both makes itself part of the dollar area, and compels itself to mint new USD-equivalent instruments to defend the peg. It is the dollar area as a whole that is experiencing monetary expansion.
Of course China is not the only player in this game. So, for example, if China were to adjust its peg to a market rate, it would still be “importing inflation” generated by other EM CBs in the BW2 game. Furthermore, even if the number of PDs on the planet was constant, the success of Chinese industry might still cause PDs to flow into China, driving up the bid for noodles in Shanghai.
This is why the word “inflation” is so confusing. Inflation is a political indicator. As a consumer, when you see price rises, it is often correct to conclude that you are competing with a counterfeiter, alchemist, helicopter, or other source of new money. If this is the case your wallet has been silently diluted, and you are right to be angry. But it could just be that money that already existed has flowed, for some nonmonetary reason, in the direction of buyers who are bidding in the same markets as you. While this remains undesirable, it does not mean you are being unfairly treated.
@ Brad
Thanks for providing a very useful analysis. Using Libor as a proxy of demand for private sector finance illuminates your pictures, as Libor adjusts rapidly to changes in risk appetite and relative currency preferences. Libor is staying stubbornly high, although down a touch with the massive injections of central bank liquidity.
If you overlaid dollar base rate and Libor on your first chart, I think you would see clearly that private sector inflows collapse with Fed base rate cuts and a corresponding spike in Libor would track the reduced inflows.
If Libor should begin seriously falling in 2008, then we could see an appreciation of the dollar and an increase in private inflows. Until then, central banks will have to take the losses of negative risk adjusted interest rates for financing US deficits.
I referred to the monetary base – because it’s what the Fed prints directly.
Consistent with this, dollarization is not the same as pegging:
“There are some substantial drawbacks to adopting a foreign currency. When a country gives up the option to print its own money, it loses its ability to directly influence its economy, including its right to administer monetary policy and any form of exchange rate regime.
The central bank loses its ability to collect ’seigniorage’, the profit gained from issuing coinage (the minting of monies costs less than the actual value of the coinage). Instead, the U.S. Federal Reserve collects the seigniorage, and the local government and gross domestic product (GDP) as a whole thus suffer a loss of income.
In a fully dollarized economy, the central bank also loses its role as the lender of last resort for its banking system. While it may still be able to provide short-term emergency funds from held reserves to banks in distress, it would not necessarily be able to provide enough funds to cover the withdrawals in the case of a run on deposits.
london banker — i presume you mean the libor fed funds spread; when both libor and fed funds were low in 03/04, there was a lot of pressure on the $ and CB intervention (tho less than now).
The Fed has many ways to create money without actually printing it. The most common is to use its power to print money to provide unbreakable loan guarantees. Thus, for example, the difference between MBIA and FDIC. This “virtual printing” is why M0 is such a bad indicator of monetary growth.
Of course pegging is not the same as dollarization, if you factor in the possibility that the peg can break. This is what happened to Argentina. Their currency board was never a real currency board. The central bank guaranteed more pesos than it had dollars to back them. Similarly, CBs in the 1930s saw their peg to gold fail for just the same reason.
Needless to say, the RMB, being undervalued rather than overvalued, is not at risk for an Argentina style event. At least not at present.
bws – thanks for explanation re flow back of CB reserves. It sounds like the US exorbitant privilege of funding in its own currency has global potential. Perhaps more countries in future will be able to run current account deficits by shorting their own currency- as the US does now – although leveraging deficit sustainability with additional gross currency mismatches may be a stretch.
I liked Summers’ Brookings piece, including the Dornbusch quote “things take longer to happen than you think they will and then they happen faster than you thought they could.” Perhaps this applies to international adjustment. Also – “economic policy making is about balancing risks”, and “recent events … the greatest failure of risk management in financial history.” I think he’s dead on re the necessity of taking credit spreads into account in interpreting the current setting of monetary policy – certainly not a view held by everybody. Considerable wisdom on the stuff of risk overall – he must have been interesting to work with.
very interesting to work with — but also initially rather intimidating. i was also struck by the “adjusted for expectations, the biggest failure of risk management in financial history” comment — both b/c it is a striking quote and b/c i am curious who in summers (elevated) circle made that comment.