The end of the United States exorbitant privilege?
There is a lot of angst right now about the dollar, and specifically about the dollar’s ability to remain the leading global reserve currency. Look at the FT leader at the end of 2007, or Daniel Gross in Newsweek’s end of the year spectacular.
Most of that angst is keyed off the (small) recent slides in the dollar’s share of global reserves. Never mind that the big slide in the dollar’s share of global reserves occurred in 2002 and 2003 – not now. And never mind that the world’s central banks have never held more dollars than they do now.
Indeed, the only thing growing faster than angst about the dollar’s status as a reserve currency is central bank holdings of dollars.
The press (even the Financial Times) as well as some currency analysts tends to report the (easily calculated) changes in dollar share of total reserves rather than changes in actual dollar and euro holdings. Almost no one tries to report the (far harder to calculate) increase in dollar and euro holdings net of valuation changes.
Yet I would challenge anyone who has looked at the actual IMF data to argue that the defining feature of today’s global economy is anything other than the unprecedented pace of reserve growth in the emerging world – and the unprecedented accumulation of dollar reserves by emerging market central banks.
The big issue facing the world isn’t the end of the dollar as a reserve currency so much as the overuse of the dollar as a reserve currency – the resulting accumulation of dollar reserves by countries that really have no need for reserves of any kind.
Take a look at a graph* showing the estimated increase — on a rolling four quarter basis — in dollar reserves relative to the over growth in the world’s reserves after adjusting for valuation changes.
There isn’t much evidence of a shortage of dollar asset accumulation. Central banks almost certainly added more dollars to their portfolio over the last four quarters than in other four quarter period.
* The preceding graph breaks out the dollar holdings of the industrial countries (mostly Japan), dollar holdings of reporting emerging economies (a group that likely includes Russia, Brazil and India), estimated dollar holdings on non-reporting emerging economies (a group that certainly includes China and likely also includes Taiwan and the Gulf economies) and estimated dollar holdings of Chinese banks and the Saudi Monetary Agency. The underlying data generally comes from the IMF, supplemented by the data SAMA releases on the size of its non-reserve assets and the PBoC’s data on the foreign currency balance of China’s banks (I’ll discuss this data in more detail in a subsequent post).
Yes, a lot of dollar and euro purchases come from countries that don’t report detailed data about their reserves to the IMF – so there is a reasonable margin of error. But the countries that do not report – China, some Gulf central banks – tend to manage their currencies against the dollar, and almost certainly still have most of their reserves in dollars. And if you prefer hard data to my estimates, just compare the red line –which shows non-dollar reserve growth of countries that report detailed data to the IMF relative to the dollar reserve growth from reported industrial economies and reporting emerging economies (the sum of the tan and light blue shaded area).
And yes, estimated central bank purchases of euro and pounds (look at the black line; it is dominated by euro and pound purchases) are certainly rising. Central banks are certainly buying more euros and pounds now than back in late 2003/ early 2004 for example. Even so, estimated 2007 euro and pound purchases are only about ½ estimated dollar purchases. They were nearly equal to dollar purchases in 2001 and, for that matter, in much of 2005.
What of total dollar holdings? They – not surprisingly – still quite large, both absolutely and relative to the world’s euro holdings. Best I can tell, the world still holds nearly 3 times as many dollars as euros as reserves.
The dollar isn’t disappearing as a reserve currency. Sure, the world’s holdings of euros are rising rapidly (especially if they are reported in dollars … ) but so are the world’s holdings of dollars.
The really big change is that close to half ½ of all dollar holdings (and about 1/3 of all euro holdings) are now coming from countries that do not report detailed data to the IMF.
So why the angst?
Well, the euro is a viable alternative to the dollar in some deep sense.
The euro already has effectively displaced the dollar as the key reserve currency of Europe. Eastern European countries, the Nordic countries and Switzerland hold most of their reserves in euros. Russia is moving that way as well. The central banks of countries that are members of the euro increasingly (I suspect) hedge their dollar holdings. And Europe is enjoying a fair amount of exorbitant privilege of its own. The rise in emerging market holdings of euro reserves is now financing European direct investment in the emerging world — much as the growth in European and Japanese dollar reserves in the 1960s financed US direct investment in Europe and Japan.
But so far the euro is basically a regional reserve currency – not a global reserve currency. The oil exporters in the gulf and the manufacturing powerhouses of Asia still manage their currencies primarily against the dollar, not against the euro. As a result they likely still add far more dollars than euros to their portfolio.
The economic logic of such an arrangement though is eroding in a less Amero-centric world economy, creating an underlying sense that the dollar’s global role is at greater risk.
The Gulf increasingly exports its oil to Asia rather than the US. It certainly buys its imports from Asia and Europe rather than the US. The East Asian manufacturing powerhouses also now increasingly trade with Europe and the commodity exporters rather than the US. Financial flows no longer map all that well to real trade flows. There is a quite plausible case that the world is now overweight dollars – both relative to the euro, and relative to Asian or oil currencies. Indeed, the real asymmetry in today’s global monetary architecture is the absence of any Asian reserve currency.
Finally,
There also is — perhaps — a growing sense the enormous increase in central bank dollar holdings may reflect political decisions that make little economic or financial sense rather than the dollar’s intrinsic appeal as a financial asset. The dollar hasn’t held its value against the euro – or held its value relative to oil. And it isn’t likely to hold its value v. most emerging market currencies. The United States supposed comparative advantage at financial engineering isn’t worth as much now as it seemed to be worth a a year ago. Broker sam cannot sell his CDOs … (more poetry here)
Finally, yhe fact that the US now depends so heavily on central bank financing also makes the US all the more sensitive to any change in the dollar’s status.
The US now relies on exorbitant privilege not so much to live well as to sustain the otherwise unsustainable – notably large private capital outflows from a country with a large current account deficit that isn’t attracting large private inflows. Without a lifeline from the world’s central banks, the US wouldn’t be able to finance its external deficit by selling under-performing financial assets. And if the US ever had to finance its deficit by selling financial assets that outperformed comparable assets, watch out. The US external position would deteriorate rapidly.
That leaves the United States in a position of intrinsic vulnerability.
The real risk though isn’t that the dollar will suddenly lose out to the euro. The real risk is that a bunch of already over-reserved emerging economies will conclude that it isn’t in their interest to hold even more dollars and euros – dollars and euros that they no longer really need – in their portfolio, and that this change will come before the US has weaned itself off its need for subsidized central bank financing.
The current wave of new sovereign wealth funds is effectively an implicit admission that most emerging economies are already over-reserved.
There is, though, another risk – namely that China and a host of others won’t change, the continued availability of such financing will allow the US to sustain large deficits without producing assets that private investors want to hold, and the overhang of unneeded and in some sense unwanted dollar reserves will grow. The result: the United States’ dependence on the political good will of its creditors will only deepen.
The United States’ heavy reliance on its “extraordinary privilege” to finance its deficit consequently is cause for concern – even if there isn’t yet any sign that the emerging world has started to withdraw the “extraordinary privilege” now granted to both the dollar and the euro.
At the crux of global economic imbalances is a credit bubble in the US Economy. There is excessive US Dollar liquidity creation by the Federal Reserve’s fractional banking system. – DC
America’s inflated asset prices must fall
By Stephen Roach
http://news.yahoo.com/s/ft/20080107/bs_ft/fto010720081324550910;_ylt=Aowq_522SCo0vjzHOs.Lr5b2ULEF
The US has been the main culprit behind the destabilising global imbalances of recent years. America’s massive current account deficit absorbs about 75 per cent of the world’s surplus saving. Most believe that a weaker US dollar is the best cure for these imbalances. Yet a broad measure of the US dollar has dropped 23 per cent since February 2002 in real terms, with only minimal impact on America’s gaping external imbalance. Dollar bears argue that more currency depreciation is needed. Protectionists insist that China – which has the largest bilateral trade imbalance with the US – should bear a disproportionate share of the next downleg in the US dollar.
There is good reason to doubt this view. America’s current account deficit is due more to bubbles in asset prices than to a misaligned dollar. A resolution will require more of a correction in asset prices than a further depreciation of the dollar. At the core of the problem is one of the most insidious characteristics of an asset-dependent economy – a chronic shortfall in domestic saving.
With one bubble begetting another, America’s imbalances rose to epic proportions. Despite generally subpar income generation, private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.
None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.
China-bashers in the US Congress also need to stand down. America does not have a China problem – it has a multilateral trade deficit with over 40 countries. The China bilateral imbalance may be the biggest contributor to the overall US trade imbalance but, in large part, this is a result of supply-chain decisions by US multinationals.
By focusing incorrectly on the dollar and putting pressure on the Chinese currency, Congress would only shift China’s portion of the US trade deficit elsewhere – most likely to a higher-cost producer. That would be the same as a tax hike on American workers. If the US returns to income-based saving in the aftermath of the bursting of housing and credit bubbles, its multilateral trade deficit will narrow and the Chinese bilateral imbalance will shrink.
Brad I wonder if you are not wanting to admit that the system itself is at risk of imploding. It certainly seems so to me.
DC
Shifting reserve growth elsewhere, to where it might be spent, might not be a bad idea. Plain and simple.
Financial Globalization and the US Current Account Deficit
Do We Really Know that a Flexible Exchange Rate Regime Facilitates Current Account Adjustment?
I think we should print FASTER
the fed needs a ZIRP! (and QE
All right, why am I the only person that seems to be alarmed by the fact that as of Jan 2, 2008, 84.79% of all the required reserves in the U.S. banking system are now being BORROWED from the Fed??!!! In the two week period ending Jan 2nd in the Fed’s most recent H3 report, the non-borrowed portion of the required reserves FELL almost $29 BILLION to only $8.7 Billion. Any monetary experts on this thread that can explain to me why I should not be concerned? And where are banks going ot get the money to repay the Fed?
BS: “…so far the euro is basically a regional reserve currency…”
“…history suggests that the euro’s chances of survival are not terribly high. The question, therefore, is when it might implode… the European Central Bank’s benchmark interest rate of 4 per cent is probably too low, given the overall inflationary environment – and definitely too low for the eurozone’s “periphery” countries… The economies of some Baltic states, and others such as Bulgaria with currencies pegged to the euro, are overheating… Failure here could shift attention to imbalances elsewhere in the union… In Italy, for example, burdensome government debt and a widening fiscal deficit leave no room at all for manoeuvre. If fiscal discipline begins to lapse, that is when the real trouble could start…” http://www.ft.com/cms/s/1/931bedbe-a8d2-11dc-ad9e-0000779fd2ac.html
I am not a big fan of the most recent Higgins/ Klitgaard paper (and I have liked much of their other work), in large part b/c the story they try to tell — namely one where portfolios globally are not becoming more concentrated in us assets — doesn’t work for the United States real creditors. EM central banks $ portfolio and $ exposure is clearly increasing rapidly, and their $ share remains well above any benchmark.
The financial globalization argument in my view confuses the rise in gross flows associated with the emergence of offshore financial centers (including London, which is an offshore center for the euro and $ zone) with “real” financial globalization. a US hedge fund based in the caribbean for tax reasons will borrow $ from us banks and broker dealers to buy US securities, generating large gross flows (financial globalization!!!) even though it is effectively mobilizing us savings to invest in us assets. the same is true of a London-based SIV that borrows $ (or used to, by issuing ABCP) from us savers (including the state of florida) to buy US assets. US savings are mobilized to invest in us assets. that isn’t financial globalization in my book. But there are two way global flows that emerge b/c of tax and regulatory arbitrage.
Since the US will absolutely not implement a fiscal tightening regime, but escalate pork barrel deficit spending, a Japan-style zero interest rate policy (ZIRP) for the US will completely destroy the Dollar as a functional monetary currency.
Ben Bernanke, don’t even think about a ZIRP for the United States.
The extraordinary privilege is supported by both official flows (correlating with the current account deficit as you point out) and private inflows (correlating with private outflows). The fact that there is little to no net private financing but large gross private financing (including return trip arbitrage as you point out) still points to the attraction of the US for dollar based risk returns. Furthermore, the downward adjustment in the dollar if anything may increase the attraction for dollar based risk returns, at least for those who are buyers of those dollar based risk assets (including official money that is gradually switching from risk-free to risky returns). Equities of US exporters should be more attractive generally, for example. Point being that the size of the gross flows through the US may remain an anchor for some time due to the persistent integration of US investment with the rest of the world, apart from current account and official support considerations.
Re: financial engineering & sustaining (the otherwise) unsustainable,
Pyramids Crumbling
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm
Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.
Official : Risk Can’t Be Measured Anymore, Moody’s Says
http://www.aleablog.com/official-risk-cant-be-measured-anymore-moody%e2%80%99s-says/
For years, three big agencies assigned risk ratings to thousands of securities, helping investors figure out which were likely to be safe investments and which were more speculative.But one of those agencies, Moody’s Investors Service, said that such ratings are no longer possible.
Guest
I would suggest that we live in new times and historic analysis does not help too much. Intellectual analysis says
a) It’s very expensive for a country to leave the Eurozone. There are several analysis of the consequences (you may find one e.g. on eurointelligence.eu) and all come to bad economical consequences. In addition there will be big political consequences.
b) Italy doesn’t matter too much, France wanted the Euro more than most others. If you look on the preEuro time, the by far most important international currency of todays Eurozone was the DM. If only one country leaves, this is not a full Eurozone breakup. If there is a breakup the regional dominating currency will be the German money. The other European countries will try to prevent that, if not for other reasons for historic sentiment.
c) There is always some populist talk which one should not take too seriously – and there are people who simply do not like the Euro, especially in UK.
d) The eastern European countries are not yet in the Eurozone for a reason. They don’t have to keep the peg.
Central bank holdings of US Treasury issues have disabled US monetary policy; the Fed’s inability to raise longs rates is in part to blame for the subprime-related financial crisis. Stupid underwriting, of course, bears the major burden of blame.
There are simply not enough Euro, BP and JPY assets to take up the slack. Central banks must continue to buy US assets.
It’s Bretton Woods revisited: we’ve simply reached the limits of the current world financial system–the US no longer controls the relative strength or weakness of its currency because it can no longer control its domestic interest rates. The global economy has begun to overwhelm the US economy. And black, female, Mormon or Baptist, the next US president will have to deal with the US becoming the world’s second most important economy. We’re dealing with it now, but the Bush administration hasn’t picked up on it yet. As usual, Bush&Co is slow out of the blocks.
But then so are a lot of others. It’s time the world woke up to the fact that the current “order” is not a system at all; it’s an unstable gas or liquid on the verge of a phase transition. Most phase transitions are contained; this one won’t be . . . as the subprime crisis amply demonstrates.
Dave Chiang is right, right now the fed has to defend the dollar, keep rates unchanged and stop pandering to the market. A low dollar means commodity prices keep rising, and the poor and middle class take a beating.
it is a matter of timing and trust. the dollar hegemony is not over until the fat lady sings and/or the north koreans switch to counterfeiting yen.
.
Smoody,
As I point out on this blog from time to time, the largest central bank holder of treasuries is the Fed itself. As at Jan 2, the Fed held 35% of the outstanding issue of the current thirty year bond and 16% of the old bond. If the Fed thinks long rates are too low, it should just sell its bonds and buy repo instead, like the ECB or the BoE.
After the US defaulted on the gold standard in 1971, a dollar became to mean “I owe you nothing”.
A euro, in contrast, has always meant by design “Who owes you nothing?”
(And a yen means “YOU owe your loyalty to the Emperor, and must stand ready to burn or turn in this bill upon his command.”)
Seriously, I’d be amazed if commodity exporters turn out to be so foolish as to just switch from dollars to euros. Because using a third country’s currency as international trade and reserve currency amounts to giving that country a free lunch. And if the problem is that the US is having too much of a free lunch, the solution cannot be to take the free lunch from the US and give it to Europe. That merely shifts the problem. The solution is that nobody gets a free lunch (gold used as international currency) or that commodity exporters start getting a free lunch themselves (THEIR currencies used as international currencies). Russia seems to get this.
So the issue here is what the US should do. Should they just wait passively to see how much further the rope can stretch and what happens next? Or should they take proactive measures? The answer depends on their weighting of the advantages of having the international trade and reserve currency versus the disadvantages of adopting a new “righer and tighter” monetary policy aimed at maintaining the dollar status by the preservation of its value for international transactions through checking its global supply growth.
Repeating from my post on the previous thread, this dilemma also addresses the issue raised by Stephen Roach that “America’s inflated asset prices must fall”. From the viewpoint of “physical inputs role and limits-aware” economics, the crux of the matter is that future purchasing power must fall in terms of tangible things because there will be less tangible things to be purchased in the future. And there are two ways future purchasing power aka wealth can fall:
A. Falling asset prices and steady commodity prices: a result of a hypothetical new tight monetary policy.
B. Stable asset prices and rising commodity prices: the current path.
Furthermore, from the viewpoint of Hubbert’s Peak, path B has the added significant drawback of accelerating – by causing relentlessly higher oil prices out of fostering aggregate demand in its current profile – the diversion of agricultural production into biofuels, thus hastening the arrival of the third horseman.
guest: I was at best premature in warning of the risk of implosion back in late 04/early 05 (with roubini) and consequently am cautious. I do think that the strains on the system are very real.
anonymous –
I agree that at some euro/$ rate, us equities become attractive for european investors, and european equities become unattractive for american investors. that seems to me to be the key signal of a potential reversal in the euro/$. the firesale begins, so to speak. the fact that german auto producers now find production in the us attractive seems like a signal.
I am not sure I see much evidence tho of gross flows through the us as opposed to gross flows through london (very large) and gross flows through europe (CB demand for euros finances investment globally, but especially in the east). for the US, it seems like global dollars (dollar-denominated savings of non-residents in the global banking system) are generally domiciled in europe if not the caribbean, and the us isn’t much of a through-train. the london based intermediation of us savings doesn’t go through the us so much as move funds out of the us for tax/ regulatory reasons and then send them back to the us.
one general thing i think has been underappreciated in the us is the extent to which europe not the us functions as the world’s real financial intermediary these days.
and more generally, the risk assets in the us that used to draw dollar based intermediaries seem somewhat less attractive these days (ntoably in the debt markets), and i am not sure if us equities can pick up the slack in a downturn.
I am not sure that I agree tho
the dangling “I am not sure i agree” in the preceding comment should have been deleted before i posted it. it was the start to a sentence that i then changed. my bad.
it should have been “righter and tighter”
Gold closes at record $880 per ounce, Up $18.30
http://money.cnn.com/data/commodities/index.html
So much for the Goldman Sachs recommendation to dump Gold last month. Paulson and company must have had a huge short position on Gold.
Remember just as Goldman Sachs was telling their Institutional clients to buy subprime CDO bonds, they were massively shorting the toxic waste. The flagship Goldman Alpha fund is down almost 60% in 2007 as Goldman Sachs stuffed the subprime crap from their company accounts into their customers Hedge Fund.
When Goldman Sachs says its time to buy Gold, then it maybe time to dump.
(1) Indeed, the real asymmetry in today’s global monetary architecture is the absence of any Asian reserve currency.
Since JGBs don’t yield anything, really, this isn’t surprising. Had yen interest rates been at 4-5% instead (yessir, I’m Hiroshima dreamin’), you can bet your bottom-scraping dollar that more CBs would be interested in holding yen reserves. But, deflation is the story out here in the real world. No dice.
(2) As a euro holder myself, I (gently) take umbrage to the concept that it is being accorded an “extraordinary privilege”. To begin with, the Eurozone isn’t even running an external deficit. Next, ECB policy is far better insulated from rent-seeking pressures from the European public and politicians to quickly cut rates Bernanke-style. While that may not be ideal for the business climate in the EU, it has done wonders to shore up the currency’s value. There are very good reasons why Trichet is the FT’s Person of the Year. To the redoubtable Mr. Trichet, “store of value” still means something. You’re a good man, Jean-Claude Trichet!
hi all,
i’m sure you will like this nice cartoon :
Money Making Machine
emmanuel — apparently the int. monetary history of the 50s and 60s is no longer taught in the UK! back at the height of European complains about its exorbitant privilege, the US wasn’t running a current account deficit either. reserve inflows financed FDI outflows ….
sounds similar.
So you think this accumulation can go on forever? If not, what would stop it? And when?
PS The ad for RGE Monitor keeps popping up relentlessly and annoyingly.
Hello Brad.
I wonder if you could make a comment about these figures from the Federal Reserve. I’ve been posting them on several blogs and no one really seems interested. Perhaps I’m an idiot, but it would look like to me that there is financial disaster in the making.
http://research.stlouisfed.org/f…OGNONBR? cid=123
http://research.stlouisfed.org/f…FORBRES? cid=123
http://www.federalreserve.gov/re…ses/h3/Current/
In the un-adjusted figures, there were only 8.7 billion dollars of non borrowed reserves in the entire banking system of the U.S. Perhaps I am too much of a financial simpleton but the figures sure look alarming.
Slumlord: I would like to take a stab at answering your question about reserves.
There are two things that come to mind, that I have come to believe over the years.
(1) In regards to the Federal Reserve Bank, it is not federal, there are no reserves, and it is not really a bank. Because the US dollar is the world reserve currency, the Fed has the exorbitant privilege to electronically print as many dollars as needed whenever necessary and they are accepted at full value by the entire world. Thus, there is no need for any reserves.
(2) This bit of information I would like to get some feedback on. From what I understand, after the gold standard was abandoned by the US in 1971, that now debt and money are equivalent and actually the same thing. And, “if all debt were paid off , then there would no longer be any money left”. Any comments?
slumlord — the links didn’t work for me.
Ditto earlier comment – The ad for RGE Monitor keeps popping up relentlessly and annoyingly
It is interesting that H&K pay virtually no attention to the issue of official flows. On the contrary, they view the level of gross flows of any type and the US share as the risk. This seems similar to your previous debate with Richard. Also, they don’t focus at all on the issue of hedge fund and SIV type used of offshore centers. I wonder if how large those flows are relative to the outstanding US IIP. Also, that type of activity must be global as well – not necessarily all flowing through the US IIP.
The H&K analysis really ignores the “quality” of the flows that you focus on – i.e. official concentration and financial engineering motivated.
Some of their important points I thought were:
“Significantly, U.S. external investment as a share of saving
has risen less dramatically than the share for other
countries. Comparing the mid-1990s with the middle of the
current decade, we see that U.S. outflows as a share of
domestic saving have risen by roughly 20 percentage
points; the increase abroad has been close to 35 percentage
points. As a result, the United States now lags the rest of the
world by a considerable margin in the share of national
saving invested abroad.
… Simply put, the proliferation
of cross-border investment worldwide has enabled the
United States to finance its growing current account deficits
while receiving a stable or even declining fraction of other
countries’ overall external investments.
…The tilt away from the United States comes despite
a near doubling of foreign ownership of U.S. assets, from
$8.4 trillion to $16.2 trillion. The reason is that other countries’
total cross-border asset holdings rose in even greater
proportion, from $17.9 trillion to $47.5 trillion.”
Hi Brad,
here are the links again, the data in question is from the St Louis Fed under Fred economic data reserves and monetary base, the data in question is in Forbes BOGNONBR.
http://research.stlouisfed.org/fred2/series/NFORBRES?cid=123
http://research.stlouisfed.org/fred2/series/BOGNONBR?cid=123
http://www.federalreserve.gov/releases/h3/Current/
Cheerio
Brad,
I think that Slumlord’s first link goes to this graphic:
http://wallstreetexaminer.com/blogs/winter/?p=1314
Courtesy of Russ Winter, BTW.
Thkx, for posting regularly.
Sorry,
While I was answering Slumlord made the good links!
But, anyway, I was right!
Emmanuel – “But, deflation is the story out here in the real world. No dice. ”
Im not too sure how u get your figures..deflation? Really?
on Higgins and Klitgaard:
“… Simply put, the proliferation
of cross-border investment worldwide has enabled the
United States to finance its growing current account deficits
while receiving a stable or even declining fraction of other
countries’ overall external investments. ”
if you think the UK is the united states leading creditor (despite running a current account deficit) that is true. if you think europe is the united states second leading creditor, it is also true.
on the other hand, it is not an accurate description of China or the Gulf. At least not in any meaningful sense (the US share may be constant, but the total is rising awfully fsat — and their claims on the US are rising v. their GDP). and i would argue that is where the US “really” gets in financing. that is where the surpluses are. and that is where the actors (notably official actors) willing to take the $ risk are.
H&K don’t dismiss official flows so much as argue that they are small. and in that sense, it very much parallels my debate with richard iley.
“Everybody ignored basic fundamentals”
So they hire these top gun mathematicians to create all of these fancy derivatives. They give them supercomputers to calculate the billions of equations their models require. They attain a level of complexity so opaque that few people know what these things really are (if anyone does). All the while, the models were built on erroneous assumptions so simple, so fundamental, that we’re all sitting here looking at each other, saying “How could ’smart’ people be so F’ing stupid?”
Meanwhile, the regulators and the central bankers, and the legislators responsible for keeping them in line, fuel the bubble with easy credit, lax oversight, and too much liquidity. They insist that there is no bubble, in fact they go out of their way to encourage its expansion, while any student of financial history recognizes that the same story is playing out yet again, and it always ends the same way.
The reckoning draws nigh.
here, here. though as the journalism maxim goes, don’t let the facts get in the way of a good story.
H&K conclude that gross inflows and gross liabilities of the US are not out of line with a ‘neutral’ US share of same. I see no reference to “official flow sensitivity”.
You’ve concluded roughly that if you strip out bank inflow/outflows and allow for financial engineering outflow/inflows, official flows are close getting close to accounting for all ‘real’ US inflows. Hence the risk.
H&K do qualify their analyses by caveats about changes in the patterns of gross flows, presumably including official flow changes.
And the global number $ 47.5 trillion outstanding of gross inflows is quite intriguing. There’s still a lot going on outside the US IIP.
Anonymous $47.5 trillion in annual gross inflows seems high — the US got i think $2.5 trillion in gross inflows in 06 (I can look it up — tis in the BEA). the gross is inflated in lots of ways –
US hedge funds domiciled in the carib borrowing US from US banks to buy US assets
Citi and other SIVS issuing ABCP from London to US investors to buy US assets.
CDOS domiciled offshore than buy US debt and then sell tranches to US investors.
and that is just the US — the same stuff happens with london vis a vis the eurozone and the like.
or even the yen carry trade –
when the mof was buying treausries, the flow was very direct. gross purchases matched net purchases.
now Japanese banks create structures apparently through the caribbean tho perhaps not that in turn buy US debt that are sold to retail investors and the like. of japanese banks lend to a European bank in tokyo that lends to its head office in London or elsewhere and then the yen are lent to a hedge fund that buys us assets. The net result is the same net flow, but a lot more gross flows.
I note here that recorded inflows to the US from japan have gone way way down since 04. Japanese investors probably are also taking more AUD and other kinds of currency risk, so the total rise in japanese holdings of us assets has slowed. but I doubt it has slowed as much as the us data suggests. rather, the new daisy chain operating offshore inflates the gross and obscures the ultimate source of funding for the US.
my more than 2 cents.
sorry – my mislabel of flows – $ 47.5 trillion is what they say is the outstanding global stock of liabilities (not flows), of which the US share is $ 18 trillion – that’s proportionate but still a big global liability number
I like the ‘daisy chain’ description – it means I think that US risk is increasingly being’re-intermediated’ to a greater dispersion and diversity of absorbers of that risk, including a greater dispersion across different countries – a ‘good’ risk effect in a way, other things equal – although it involves gross flow and stock inflation – of course other things are never equal – plus all of the off-balance sheet activity
Guest: So they hire these top gun mathematicians to create all of these fancy derivatives. They give them supercomputers to calculate the billions of equations their models require.
In practice, hardly anyone uses supercomputers in finance. Most systems run on clusters of standard PC’s. The reason people run clusters is that you need the risk numbers for the next trading day.
Guest: They attain a level of complexity so opaque that few people know what these things really are (if anyone does).
Simple models are usually the best because you see what is inside of them. The reason that you need massive compute power is not model complexity. Rather its because you need to run a relatively simple model against tens of thousands of instruments.
Also the simpler the model, the more computation time it takes to calculate things. Monte Carlo is dead simple to explain. I take a coin and flip it. If the coin reads heads, I assume the stock goes up. If it reads downs, it goes down. Repeat a billion times.
Analytic models are fast. I writing an equation, and calculate it. Trouble is, to reduce the problem into a single equation, I have to make dozens of assumptions and guesses.
Guest: All the while, the models were built on erroneous assumptions so simple, so fundamental, that we’re all sitting here looking at each other, saying “How could ’smart’ people be so F’ing stupid?
They weren’t. If you run any CDO model around 2005, it’s clear that you would have a problem. So the mathematician raises the issue with his managers and one of three things happens.
1) the numbers get ignored. If some geek tells you that you should be investing in something that is bringing billions to the bank and hundreds of thousands to you personally, you can easily find a way of ignoring them if you don’t want to listen to what they have to say….
2) the numbers get listened to and the banks don’t go into some lines of business
3) the numbers get listened to and the bank comes up with a strategy to make massive amounts of money from the crash
Now you could argue that the geeks were partly responsible for the near crisis in the stock markets on August 7,8,9, but you just can’t blame “complex models” for the subprime mess. All of the mathematical models clearly showed that there was going to be a big, big problem, and anyone who says otherwise is just trying to shift blame for not listening to the quants.
DC: Remember just as Goldman Sachs was telling their Institutional clients to buy subprime CDO bonds, they were massively shorting the toxic waste.
Different parts of an investment bank aren’t allowed to talk to each other without a lawyer present. It’s not surprising that analysts have recommendations that are inconsistent from that people in the private side are doing.
DC: The flagship Goldman Alpha fund is down almost 60% in 2007 as Goldman Sachs stuffed the subprime crap from their company accounts into their customers Hedge Fund.
This isn’t what happened. I should note that I have no inside information about Goldman Alpha fund, but it is similar to other quant hedge funds that I do have publicly disclosable information about, which is part of the problem. You have so many stat hedge funds running the same strategies. Goldman Alpha has no direct CDO or subprime exposure as far as I know.
Now someone (probably not Goldman) had to liquidate some of their stocks in order to pay for subprime losses. So this caused the market to do down. Since you have all these hedge funds running the same stocks, everyone sold at the same time, which meant you have a mess on August 7, 8, 9.
This has resolved itself, and most quant hedge funds were down only slightly for Q3, and up for Q4.
This is one area where you can blame the quants, since most models for stock purchases didn’t take into account the fact that everyone else had the same model. But it is only a very small part of the total problem.
Brad,
Great post. You are of course expert in the effect of reserve accumulation on financial conditions in these emerging market creditor economies, and impacts on growth and inflation, but I wonder though if you wouldn’t comment on the circularity here. As some analysts have pointed out, the circularity of cause and effect in reserve accumulation accounts for the above exponential chart, (and things like robust global economic growth, soaring commodity prices, and ultimately, the narrowing of the US trade deficit).
The mechanism I am referring to is that the suppression of market interest rates & spreads by recycling reserves back into the US bond market incentivized borrowing, (and concomitantly buoyed the asset prices that secured so much of it), thereby keeping the engine of growth stoked with fresh capital. The reason why this postulated simplification explains the shape of reserve accumulation is simply debt trap dynamics: finance is increasingly applied to financing costs, meaning that more and more debt is required to finance consumption growth, and this is what we have and continue to see (though the rate of debt growth is clearly decelerating). The case is even more compelling when you construct the consumer balance sheet, which manifestly shows that at least this sector (70% of the economy) is nearly totally dependent on finance for cash flow because such a large component of disposable income is spoken for.
I wonder if you are sympathetic to that simplification and if so, what might the implications be for the US and global economy of deflationary forces in the US, (namely, defaulting borrowers, slowing economic growth and an improving trade balance), and whether any event set in motion by these dynamics, (including potential central bank actions), could inspire panic in the official dollar holding community macabre economists have been speculating about for some time. Thanks…
Slumlord:
The Fed has had for many years the power to create any amount of IBDD’s (Interbank Demand Deposits). There are no reserve or reserve-ratio restrictions on the credit-creating capacity of the 12 Federal Reserve Banks.
The newly created IBDD’s can be put at the disposal of any bank in the System through the “discount window” or in the present situation the Term Auction Facility. These deposits are not only money to the recipient bank, they also become a part of the legal reserves of the System. And therein lies a limitation.
One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances have to be repaid in 28 days is immaterial. A new advance can be obtained, or the borrowing bank replaced by other borrowing banks. The importance of controlling borrowed reserves is indicated by the fact that at times nearly 84.7% of all legal reserves were borrowed (using your figure).
The Fed cannot increase the legal reserves of the System without creating the basis for a multiple expansion of the money supply (multiple in terms of the incremental reserves). The Fed can, and does, offset borrowings with open market selling operations, thus eliminating any net increase in bank legal reserves.
Therefore, with the rescue operation of the TAF’s dimension, it has offset TAF auction credit with open market selling operations of U.S. Treasury Bills
(-) 61,659 (H4.1) 1/10/08.
1: the full faith and credit of the united states is what backs this all up.
2: when there is no more faith, thats the problem.
3: obviously the credit is based on faith.
4: what is the “faith”?
5: in essense, faith in G-d.
6: that faith has gone.
7: restoring faith is absolutely NOT trading thee only ally in for oil.
8: thats the essense of treachory.
NOT FAITH.
=Prepare for rough times.
This story is as old as the hills.