Brad Setser

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Too big to fail? Or too large to save? Thinking about the US one year into the subprime crisis

by Brad Setser
July 24, 2008

Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.

A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets. Then again some of the expansion of their balance sheets may not have been entirely voluntary, as off-balance sheet assets and liabilities moved on to the formal balance sheet.

Residential investment has fallen significantly as a share of GDP.

But in other ways, the US hasn’t adjusted.

Or rather, US policy adjusted so that the economy didn’t have to adjust as much. And other key countries – notably the countries that finance the US – didn’t adjust the policies (notably dollar pegs) that effectively compel them to finance the US. Many key countries — notably China — have exchange rate regimes that seem to require that they provide more financing to the US when the dollar is under pressure.

The US went into its crisis with a large current account deficit. And – as the Levy Institute (see Figure 2 here, and more here) and others, including Martin Wolf, have documented – the external deficit corresponded with a large deficit among America’s households. Households didn’t save. They also invested in new homes. As a result, US households were net borrowers from the financial system — and ultimately from the rest of the world.

US firms weren’t all that exuberant in the run-up to the crisis. They weren’t investing all that much. PE firms were more exuberant, but their business strategy was based on gearing up existing cash flows to increase equity returns, not new investment. That is likely why the rise in business borrowing (see figure 3) late in the last cycle didn’t prompt a strong rise in business investment or overall growth.

The government was running a structural fiscal deficit. However, that doesn’t explain the persistence of the US current account deficit after 2004. From 2004 to 2006 the fiscal deficit shrank. In 2005 and 2006, the growing deficit of the household sector drove the expansion in the overall deficit.

The resulting overall external deficit was financed, at least in part, by the buildup of dollar reserves by the world’s central banks – not by a buildup of dollar-denominated financial assets among private investors abroad. Someone in London was buying US corporate bonds — a category that includes a wide range of asset-backed securities. But the crisis has revealed (I think) that much of that demand came from vehicles sponsored by US and European financial institutions that funded themselves by borrowing dollars. They took on credit risk, not currency risk.

A year or so later, and not all that much has changed.

The US household sector still runs a deficit. Household savings isn’t falling anymore, but it also hasn’t really increased. Rising oil bills have eaten into spending on other items, but overall spending is holding up. Residential investment is down. But the household sector as a whole still runs a deficit — though a somewhat smaller deficit than before.

However, the fiscal deficit has expanded. The government is borrowing, in a sense, to provide funds to cash-strapped households to support demand.

Mortgage lending hasn’t even collapsed. Demand for “private” mortgage-backed securities has disappeared. But the Agencies stepped in and bought mortgages both for their own book and for the mortgage-backed securities that they guaranteed. The Economist wrote last week:

“With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January. So they will need to keep lending. Nor is their scope to offload their portfolio of mortgage-backed securities, given there are scarcely any buyers of such debt. And if the Fed has to worry about safeguarind Fannie and Freddie, can it afford to raise interest rates to combat inflation?”

The Economists thinks the Agencies’ financial weakness is a constraint on US monetary policy. The same might be said of the financial weakness of many private financial institutions. Even if US monetary policy isn’t constrained, there is little doubt that the Fed has stepped in to help the banks and broker dealers meet liquidity pressures without dumping their existing assets. A lack of confidence in “private” collateral that increased demand for treasuries in the US financial sector has been met by allowing a number of institutions to borrow the Fed’s Treasuries.

These steps avoided a super-sharp emerging-market style adjustment.

But a country that runs a large external deficit doesn’t need to just keep credit flowing inside its own economy so that existing “deficit” sectors can continue to run deficits – it also needs an ongoing flow of funds from the rest of the world. The US has gotten that, too.

Not thanks to private investors. Private demand for US debt has almost certainly dried up, though the limits of the TIC data make it hard to demonstrate this conclusively. The last survey concluded that all “private” demand for US Treasuries and Agencies came from financial intermediaries who sold their Treasuries and Agencies to central banks (there wasn’t an increase in private holdings from mid-2006 to mid-2007). If that is still true, central banks total purchases of US financial assets over the last 12 months are now running at close to $680 billion ($330 billion in recorded official inflows — counting short-term flows — and $350 billion in “private” purchases of Treasuries and Agencies). Private demand for US corporate bonds and equities, by contrast, has fallen sharply. Corporate bond purchases over the last 12ms were only $170 billion or so — down from an annual pace of over $500 billion a year before the crisis. Demand for US equities is also down ($65 billion in the most recent 12ms v $175 billion in the preceding 12ms)

And remember, some “private demand” comes from funds that are investing for sovereign wealth funds.

Why has so much credit been available to the US during its crisis, when similar credit wasn’t available to emerging markets facing trouble? My answer is simple: other countries didn’t adjust their macroeconomic policies even as the US adjusted its policies – lowering rates, loosening limits on the Agencies so that they could expand their books and adopting a counter-cyclical stimulus – and the interaction between the shift in US policy and limited policy changes abroad produced the flows the US needed.

Europe kept its rates up. It even raised them recently. That pushed the euro up – and helped the US export sector. It also put pressure on countries maintaining dollar pegs, whose currencies were depreciating against the euro and whose central banks faced pressure to lower rates.

The PBoC didn’t exactly follow the Fed, and the RMB didn’t exactly follow the dollar. But the RMB generally fell v the euro. And while China didn’t follow the Fed’s rate cuts, it kept rates more less unchanged as inflation rose, pushing real rates down. That supported investment in China even as higher rates than in the US led to a surge in capital inflows and reserves growth. The RMB’s depreciation against Europe — and the boom in resource exporting economies — kept China’s export growth up. Net exports contributed positively to China’s growth in q3 07, q4 07 and q1 08 (we still don’t know for q2 08).

No adjustment there.

The Gulf kept its peg to the dollar (or in Kuwait’s case, a dollar heavy –basket); Russia kept its euro-dollar peg. Both increased spending and government-sponsored investment as well. The combination of wildly negative real interest rates, a nominal depreciation and fiscal expansion generated an enormous boom. But with oil prices rising faster than spending and speculative pressure on dollar pegs, it also required a huge increase in the foreign assets of the oil-exporting economies government. The oil-exporters basic macro policy stance – dollar pegs, fiscal expansion when oil is high (and contraction when it is low), and monetary policy imported from the US – didn’t change.

The overall result was an increase in official asset growth — which has been running at close to $400 billion a quarter recently, or over two times the size of the US deficit. A tiny bit of that went into US and European financial institutions during the early stages of the crisis – at considerable cost to the sovereign funds that made the investment. But most has gone into safe US Treasuries and into Agencies.

Kevin Drum – rifting off Dr. Duy’s Magnus Opus – argues that the system will be stable so long as foreign investors continue to have “faith …. in America as a good place to invest their money.”

I don’t think that is right. The US hasn’t been a good place for foreign investors for some time, now: US rates haven’t compensated for the risk of dollar depreciation, and US equity markets generally have underperformed. That hasn’t kept foreign governments from buying. Their demand for dollars reflects their decision to manage their currencies against the dollar — not their assessment of the dollar’s attractiveness as a store of value. The worse the dollar does, the more foreign central banks tend to buy …

Foreign governments have been willing to take on the currency risk associated with financing the US. But foreign governments didn’t want the credit risk associated with lending to US households. The US government – and its intermediaries, notably the public-private Agencies – stepped in, helping the market to clear and avoiding a sharp contraction in global demand.

That, at least to me, explains in broad strokes how we got where we are.

The policy response to the subprime crisis has avoided the sharp adjustment that many feared. But it also meant that many of the underlying imbalances haven’t really corrected. The composition of the US current account deficit has changed – the oil deficit is bigger, the non-oil deficit is smaller; the fiscal deficit is bigger and aggregate deficit of households is smaller – but the aggregate deficit remains large.

And the rest of the world’s imbalances haven’t corrected either. China’s economy remains unbalanced. The oil surplus has gotten bigger.

Hence it is possible to argue — see Yves Smith — that risks are still increasing.

Or it is possible to argue that the existing system has demonstrated its resilience under stress, and there isn’t good reason to think it will break now if it survived the stresses of the last year.

So far, the US has been both “too big to fail” and “too big for the emerging world to save” without incurring real costs.

The costs of dollar pegs are more and more apparent. But the costs of letting go now – before private demand for US assets has materialized or the US deficit has shrunk to a level that could plausibly be financed by a modest pickup in private demand for US assets – are also high.

I have no clue how long an equilibrium based on not letting go can last. Policy makers have succeeded — even the absence of overt coordination — at avoiding the worst. That is a good thing. But I would be a bit more comfortable if a bit more adjustment had happened over the past year.


  • Posted by anon

    Central banks finance the deficit at the exact point they buy the dollars that the US exports via the deficit. They buy treasuries and agencies because, essentially, they have nothing better to do with the money, and they must do something with it. The exchange rate policy is the preeminent one. It is the critical risk, moreso than the funding pattern corresponding to the assets that are purchased with the dollars.

  • Posted by Michael

    This isn’t the first time the U.S. has had too many dollars abroad and couldn’t imagine that the holders of those dollars would suddenly stop caring about the financial stability of America and start dumping them. After WWI and again after WWII countries (to whose rescue we came in both wars) initiated sudden runs (initially the central banks) against the dollar by demanding to exchange them for gold (which was an official reserve for the currency). This led to the 1934 and 1971 dollar/gold breaks. I’m sure we’ll be just as surprised and shocked this time when Treasuries and Agencies get dumped and the dollar is abandoned as the world reserve currency.

  • Posted by anon

    The allocation of required capital inflows tends to be somewhat arbitrary. It is assigned, variously, depending on desired message, to S – I (e.g. housing), the current account deficit itself (vendor financing), treasury and agency financing requirements (investment portfolio sampling), and the Iraq war (politicians). Very fungible and flexible concept.

  • Posted by Matt Dubuque

    I believe there is a dramatic risk that the adjustment you seek will occur within the next few weeks.

    The GSE rescue bill about to be passed clearly seems to envision that GNMA and FNMA shareholder value will be essentially wiped out if the Treasury provides an equity infusion. I posit that this is why FNMA and FRE share prices have once again collapsed in the last two days.

    It seems that there is a clearly material risk that by this time next week global psychology will take dramatic turn for the worse due to the psychological trauma of an absolute collapse in FNMA and FRE stock.

    This thesis is further supported by the collapse in oil and other commodities over the last week.

    We run a growing tail risk of a very nasty bout of a term I coined in the FT.

    That term is HYPERDEFLATION.


  • Posted by RealThink

    Brad, that’s a really good description of the ongoing movie and current picture. I will add a key (IMV) consideration that makes the 2008 US case different from those of 1997 Asia and 2001 Argentina: back then the world was still far from the physical limits to growth, while now it is bumping against them, most notably in, but not restricted to, the global extraction rate of oil.

    In this new scenario, the assumption that oil exporters will indefinitely continue exchanging their often only resource, which comes from an exhaustible, finite endowment, for ever greater quantities of printed paper with ever less purchasing power is, to say the least, rather risky.

    Therefore the KEY point is: What should the US do with the external financing while it last?

    From a Hubbert’s Peak-aware perspective, the best path would be to let mortgage financing dry up and residential (and business) construction in its current form come to a screeching halt. Because construction of more suburban, energy-inefficient McMansions is just digging further in the already deep hole most of the US population is in, as higher fuel prices will turn those homes into traps for their occupants.

    Instead, the US needs to employ its labor and (ever more scarce) physical resources in a massive wind farm construction plan like Al Gore proposed recently.(*)

    To note, I am not proposing a default on current Agency debt. I object to creating new Agency debt.

    (*) Related to this, IMV the cars-on-natural-gas part of T. Boone Pickens plan is nonsense. Cars should go electric or at least PHEV (that’s why the US needs so much wind power). Natural gas is too important for cooking and heating.

  • Posted by Twofish

    bsetser: Why has so much credit been available to the US during its crisis, when similar credit wasn’t available to emerging markets facing trouble?

    I think it has to do with having 11 carrier battle groups, about 8000 nuclear bombs, a military that is larger than every other nation combined, and issuing the currency which is the basis for the global economy. When Indonesia or Mexico fell apart, no one in the US cared, but if the US falls apart, it will take the entire planet with it, and everyone knows this.

    The US has created the most powerful empire in human history and having created the world’s most powerful empire, it can and does get tribute from the rest of the world.

    It’s good to be the king…….

  • Posted by aim

    Most of the world’s eggs are in the dollar basket. They simply cannot afford to abandon the dollar. Maybe when US housing prices begin to recover then ajustments will be made. But I think it is going to be awhile.

  • Posted by bsetser

    anon — technically, you are right. central banks buys dollars ( a us asset) when they intervene. after that they just shuffle between dollar assets. I don’t want to discount that reshuffling — a world where the official sector buys $1 trillion of us equity is different than a world where the official sector buys $1 trillion of us debt. and, of course, just ’cause you buy a dollar doesn’t mean that you hold a dollar — dollars can be sold for euros, if there is a buyer. but I agree that the key decision is the decision to step into the market to begin with and to purchase dollars.

  • Posted by Richard Kline

    Those non-US central banks are using neg real rates as a significant lubricant in their ‘unlimited quality purchase’ policy. This strikes me as a bet that they can endure the consequences—including specifically ballooning inflation—long enough for real growth to return in the US. . . . While in the US real growth is only just entering the steep part of the cyclical decline phase. We aren’t near the bottom at all, and in fact the cost of subzidizing the big currency pillow under our corpulence hasn’t even begun to bite. I think that their bet will crap out if they stay in. Will they re-negotiate their policies, and when: that is the issue, to me?

    Twofish: The US is most certainly _not_ the most powerful empire in history; that is a nonsense phrase that is better left to the chattering classes. Our military efficacy is much over-estimated. I do not believe that other countries are financing us because of our army or our nuclear bombs. Oh, that was certainly the policy, wish, and fantasy of the political faction embedded in the current, failed US Administration, but we see what their perspective is worth, now. Those central banks are financing us because their own macrofinancial strategies are completely tied to the standing of the $ and the US as of 1985. They will continue financing us until they exit those strategies for new ones.

  • Posted by Rien Huizer


    As a renaissance person with holistic approach to economic policy probrems, it was only a matter of time until the military side of the US came up. When Istarted to read the sentence bout the carrier battle groups (clearly not the Coxinga class) etc, I thought that it was going to explain the natural deficit effects resulting from this mighty apparatus. But you were looking instead at this as an investment, and one returning seignorage benefits.


    I am sure no one would lend to the US if it did have the same hopeless economy, poorly socialized consumers and dysfunctionl politicians, without this highly productive (or destructive) military apparatus. It may not be ideal against the Mujaheddeen or whatever, but it is still capable of destroying all of the urban areas with more than 5 million people wihin one hour. The tridents alone could do that, assuming most are still operational (the Ohio itself was recently converted to something a little more war-fighting I believe). Staying clear of Russia (or warning them in advance) and of course also saving allies like Europe and Australia, would be a very different game than WWII. Not so sure the Chinese assets could survive a first strike. But then, where would Walmart get its merchandise from?

  • Posted by Michael McKinlay

    This situation is only temporary. As Europe, Japan and the US go into recession there will be less of an appetite, indeed less trade surplus to satiate our growing debt.

    Countries will have to start worrying about their own budgets as exports slide and oil and coal again rear their ugly head in the commodity markets. We are already seeing social unrest around the world. It will only get worse.

    There is going to be a reckoning, probably this fall. I was taken aback by this latest panic. I thought they could at least keep it together until the elections but they couldn’t. Not a good sign as to the magnitude of the problem coming our way.

  • Posted by Gregor Neumann

    Brad (+Twofish):

    „Why has so much credit been available to the US during its crisis, when similar credit wasn’t available to emerging markets facing trouble?”

    Because of the sheer size of the problem and the Fed’s decision to prevent a rapid adjustment. To get rid of excessive credit, the financial system has to deflate the bubble. The discount window and low interest rates are a counter balance to the deleveraging that is clearly taking place. The Fed is absorbing today instead of stimulating growth after the slump.

    If everybody wants to sell at the same time, the situation gets worse, if there are no buyers. So everybody who is interested in stabilizing the financial system, is buying, even it is clear, they are buying at an inflated price. They hope that a slow deflation will mean less harm to their other holdings.

    If the US drowns quickly, everybody else is drowning with them.

    So instead of a hard, painful crisis we are heading into a prolonged mid-size crisis. Because the real trouble starts, when the US has reached the bottom and needs credit to rise again. There might be a risk premium involved with that.

  • Posted by Rien Huizer

    Continud, Of course it should not have been WWII, but the cold war.

    Nevertheless, Brad’s question is the one that keeps us all awake at night, and no one knows. The least likely thing is that US politicians will make domestic sacrifices (absent a freak event, for instance terrorism, or an adventure of one of the many belligerents in the middle east involving ral damage to important things like the Suez Canal, of the Ghawar field (not that easy). The point is that this sitution should not break down with a very deep US recession. If that happens, all kinds of uncontrollable effects would occur. But, the US needs to adjust to a very different international economic environment from what id had only 20 years ago. The seignorage game (I hope no one took the previous post seriously) can only work if the Emperor demonstrates both his ability to destroy and his ability to build. In the past 20 years we have seen very little of either. A state with a more barabaric ethos (or historic legacy) would have used nuclear weapons (or developed war fighting versions) a long time ago. The US is simply not internally organized for a long term imperial role, and her ruling class is socialized in a different direction.
    The way things are going the dwarfs will find a way to either get rid of Gulliver, or destroy him. No one can know how, but it will, and it would be a terrible step back for human civilization if it did. More or less like a dynastic change in ancient China

    I have lng argued (privately) that the rest of the world should pay the US for its work, and institutionalize a supranational role for the US strategic forces, which then should be used occasionally, against true rogues who peddle or develop unregulated nuclear arms or similar instruments of warfare. That was the role the Europeans envisaged for the US after WWII. Instead, the US supported poorly designed decolonization and fought a few wasteful, conventional wars, clumsily. Who cannot handle pain will never win a fight, as the saying goes..

  • Posted by Twofish

    Kline: The US is most certainly _not_ the most powerful empire in history.

    Care to name one that was more powerful? Also, being a powerful empire is not necessarily a good thing. If you look at classical writers, being an empire causes havoc with your domestic institutions.

    The US expedition in Iraq reminds me a lot about the Athenian expedition into Sicily, and Alcibiades sounds like someone I wouldn’t be surprised to find in the Bush administration.

    Kline: Our military efficacy is much over-estimated.

    Which means that it is doing its job. The purpose of a military is to prevent war, and the perception of power is much more important than the reality of power. If everyone thinks you have a powerful military to the point that you don’t have to use it, then you have a powerful military.

    If everyone vastly overestimates the power of your military, and hence does not challenge it, then it is great for you. The danger here is if your own generals start believing their own propaganda.

    The major weakness of the US military is that it is funded by borrowed money. Also something that concerns me is that there is this trend from citizen-soldier to professional mercenary that tends to be corrosive to civic institutions.

    Kline: I do not believe that other countries are financing us because of our army or our nuclear bombs.

    I do. I doubt Beijing or the Saudis would give the US one nickel if it didn’t have its military. After all, China and Saudi Arabia aren’t funding the Canadians that much.

    Kline: Oh, that was certainly the policy, wish, and fantasy of the political faction embedded in the current, failed US Administration, but we see what their perspective is worth, now.

    I’d argue that the great failure of the current administration was they that refuse to see how the US is an empire. They really believe that the US is a champion of democracy, but empires always talk about their civilizing mission.

    The United States acts like an empire, and while you can put some of the blame on the current administration, some of the blame has to be put on the voters who put them in office, because people in the US benefit a lot from being an empire, in that they get low interest loans for houses, are able to spend lots in credit cards, and drive these huge SUV’s. Any politician that goes against this is just not going to be elected.

  • Posted by AC

    Brad – I would like to ask the same question again, that I asked in the comments of a previous post: do you think that China needs to buy about 700 billion USD (70% of the estimated 1 trillion reserve growth) this year to keep the yuan from rising too fast? Or a larger percentage of this 1 trillion will go into the reserves in other currencies? What I don’t understand is why the POBC buys all the foreign currency offered to them? They should just buy the amount that is enough to keep the yuan on the preset course, and refuse to buy the rest. I don’t think that people would start to keep dollars or a dollar-based black market would develop. Everybody knows that the yuan deposit interest rates are higher, and the yuan will eventually rise, so they want to have yuan, not dollar.

  • Posted by Dave Chiang

    Here’s how Economist Dr. Michael Hudson sums the current US financial situation up:

    “The few checks and balances that remain in the way of the financial sector’s increasingly centralized planning, especially at the state level, are being swept aside under the guise of “saving the system.” Few Wall Street beneficiaries who use this phrase explain just what the system is. For starters, its political managers are industry lobbies appointed to high managerial and planning positions in the public agencies that are supposed to regulate these industries. Their idea of financial planning is to put a trillion dollars in government agency funds and credit guarantees at risk. This agency funding was supposed to be used to help average American families obtain housing and health care, and to protect their savings and provide for their retirement. Instead, it is being mobilized to support the economy’s bankers and financial managers. Indeed, the past few weeks have seen seemingly trillions of dollars committed for war making and bank bailout support.

    The banking system’s free creation of credit, doubling each five years or so for the economy at large, threatens to culminate in debt peonage for many American families and also for industry and for state and local governments. The economic surplus is being quickly absorbed by a combination of debt service and government bailouts for creditors whose Ponzi schemes are collapsing right and left, from residential to commercial real estate and corporate takeover loans to foreign bubble-economy credit.”

  • Posted by Dave Chiang

    The real winner from the Cold War was’t the United States. – DC

    Japan holds world’s top creditor-nation spot for 17th year

    TOKYO, May 23 (Reuters) – Japan’s net external assets rose to a new record high in 2007, government data showed on Friday, making it the world’s largest creditor nation for the 17th year running.

    Japan’s overseas assets rose 9.4 percent from a year earlier to a record 610.492 trillion yen ($5,862 billion) last year as domestic investors put more money into foreign assets, Ministry of Finance data showed.

  • Posted by bsetser

    AC — So long as the PBoC wants to set the rmb/ dollar rate, it has to buy all the dollars offered at that rate. otherwise there are excess dollars in the market, and the rmb would need to rise until someone was persuaded to trade their rmb for dollars. so the pboc can only reduce its purchases if it:

    a) allows the rmb to rise to a point where there is less demand for rmb and more for dollars
    b) if capital controls reduce demand for rmb by limiting the ability of various players in the market to trade rmb for dollars.

    right now china is trying b). That may have reduced its pace of reserve growth from $900b to more like $700-800b. Time will tell.

    as for whether china can sell its dollars for other currencies, the answer is clearly that it can — read macroman’s periodic complaints about SAFE’s activities in the market for euros. SAFE’s ability to buy other currencies is a function of:

    a) how much its purchases move the market — i.e. if it wants canadian dollar or euro, does the price rise?

    b) how much China cares about a rise in the euro/ rising canadian dollar against the US dollar, and ultimately against the RMB.

    c) how much weight China assigns to pressure from European (and other) governments not to buy a ton of their currency and push their currency’s market price up.

    I don’t know the full answer to a) and b) or c). I am pretty confident some European leaders have told China that they don’t want more Chinese purchases of Euros.

    China clearly has some Canadian dollars. But Canada is a much smaller country and economy than the US and i doubt it could absorb say a $100b (US) inflow from China. $20b might be big v the Canadian market. China is probably buying close to $200b (euro 140b) of euros a year right now, and some think that has added to the pressure on the euro …

    Ultimately, when you are talking about purchases on China’s scale, the big economies almost have to absorb most of the flow.

  • Posted by AC

    Brad – Thank you for the explanation.

  • Posted by Dave Chiang

    China’s Parliament demands Central Government do more to support sagging exports

    China’s parliament on Wednesday urged the government to do more to curb inflation, while also calling for more policy support for the export sector.

    It said China’s policymakers should consider introducing favourable policies for the textile, clothing and toy sectors to cushion the impact that a slowing global economy has had on the exporters.

    On the currency, the committee said China must curb increasing inflows of speculative capital, or hot money, and weaken appreciation expectations.

  • Posted by Rien Huizer

    Twofish? Alcibiades (just rereding Republic, Thucydides and Aristotle on democracy) scratch, scratch. Alcibiades used to be away a lot when things became difficult and he had some loyalty problems. Plus he shared some Spartan tastes. Batman?

  • Posted by Dave Chiang

    Because Washington Mutual is the next large bank to go under, those depositors under the FDIC $100K limit will likely get fully paid back. But surely we won’t be able to say the same thing if/when a few more of these go under? Here Aaron Krowne talks about the sorry shape of the FDIC:

    “One aspect I’ve heard no one mention is the inevitable effect FDIC bailouts will have on the bond market and government finances.

    The FDIC only really has about $5 billion in actual cash. The IndyMac failure alone will blow that away. But the mainstream media seems to not think this is a problem. I think it is.

    That is because the rest of the FDIC’s $50+B fund is… (drumroll) Treasury securities! (the fictitious savings vehicle of choice for government bureaus). If they desire to actually make good on all their IndyMac obligations, and then any other bank failures that come down the pike, they will have to do a lot of selling of Treasuries. This will be painful on at least four counts:

    1. It will be selling of Treasuries at the worst possible time, adding to the onslaught of supply and forcing yields up.

    2. It will be inflationary, monetizing a bunch of debt that was previously “sequestered” inside the FDIC.

    3. It will deplete the FDIC’s fund for (near) future crises.

    4. It will be very painful for banks in general and/or the government, as virtually no banks can afford the luxury of exchanging cash for Treasuries right now, and the Federal government can’t afford higher borrowing costs (and really doesn’t want to have to “print”, though it is barreling headlong in that direction).”

  • Posted by Bill C

    Although the US situation is unique because of its size and the reserve currency issue, so we should be cautious about drawing inferences from past crises, the evidence on current account reversals in OECD countries (e.g. Caroline Freund, Jl. Intl. Money and Finance, 2005) suggests that Argentine-style “sudden stops” are unlikely for a rich country. The general pattern is a growth slowdown, exactly like what we’re having, but not a crisis, with export growth and an investment slowdown.

  • Posted by Dave Chiang

    The Australian Bank NAB has pulled the pin which may detonate inverted debt pyramids everywhere. Australian Bank writes down by 90% the value of AAA-rated US Mortgage securities.

    If this gets legs, it will be a significant global inflection point. No more hiding behind ‘Level 3’ or other such fantasy camouflage. It also makes a government bailout impossible, as the numbers are simply too large to quantify properly.

    “Dag NAB It! How NAB’s Writedown of U.S. Portfolio Could Hurt Financials”

    “Alan Kohler in todays Business Spectator says NAB’s decision to go straight to 90% provisioning on their portfolio of US residential mortgage-backed securities (RMBS) is a shocking event that will reverberate around the world.

    Much of NAB’s book was made up of AAA securities, so to mark them down so drastically certain suggests that “the model”, whatever it is, is broken. Now, when you consider that a whole host of banks are either marking this stuff much higher on their balance sheets, or have moved it to the limbo of “Level 3″ make-up-whatever-price-you-want assets, a publicly-disclosed 90% write-off on similar assets could represent a rather unpleasant dash of cold water in the face of much larger fish than NAB.”

  • Posted by Twofish

    DC: If they desire to actually make good on all their IndyMac obligations, and then any other bank failures that come down the pike, they will have to do a lot of selling of Treasuries.

    No they won’t. The can just move the deposits over to another bank and the recapitalize the deposits by moving over treasuries. At any given moment the amount of bank deposits that is in the form of cash is very small.

    DC: Alan Kohler in todays Business Spectator says NAB’s decision to go straight to 90% provisioning on their portfolio of US residential mortgage-backed securities (RMBS) is a shocking event that will reverberate around the world.

    That tells me that Alan Kohler doesn’t understand much about finance.

  • Posted by bsetser

    Bill C — I would note that the fall in foreign demand for US “corporate” debt looks a lot like a sudden stop, and the fall in issuance of “private” mortgage backed securities looks like a sudden stop. to the extent these were key vehicles for financing the us deficit, the US could have been the first industrial country “sudden stop” but for offsetting actions.

  • Posted by Michael McKinlay

    The Shot Heard Round the World …

    NAB will shock Wall Street

    The National Australia Bank’s decision to write off 90 per cent of its US conduit loans will have dramatic repercussions around the world. Wall Street will be deeply shocked when they understand the repercussions of what NAB has done. It is clear global banks have nowhere near provided for their exposures to US housing loans which in the words of John Stewart are experiencing a “meltdown”.


    I suppose the privately owned Federal Reserve and the US Treasury could just ignore this development… but for how long ?

  • Posted by don

    One aspect of the global slowdown puzzles me. Demand for China’s exports is a function of their price and income in the customer countries. If customer incomes fall, a larger price discount will be necessary to keep up China’s exports. But the same net currency intervention will result in the same current account surplus (ignoring offsetting capital flows). So, does this imply the same amount of intervention will bring forth a greater effect on exchange rates?

  • Posted by AJ

    Brad- I wonder if the trigger to adjust will come from an internal crisis in China’s financial system. As Michael Pettis noted yesterday China’s mortgage market actually looks a lot like the US market in 2006 and their financial institutions are even more precarious, I’d imagine they’d have trouble holding up their own internal finance system and the US at the same time.

  • Posted by ZFC

    AJ: “As Michael Pettis noted yesterday China’s mortgage market actually looks a lot like the US market in 2006 and their financial institutions are even more precarious”

    Pettis quotes Yi Xianrong of CASS in an FT article. One quote: “Anyone can get a mortgage loan in China.”

    Ummm, no. The Chinese need to put down 30% for a mortgage. Pettis (or FT) should have at least pointed this out. The level of defaults in residential mortgages in China is certainly not going to play the same (positive feedback) role as it is playing in US housing deflation (e.g. foreclosures up 100% YOY).

  • Posted by don

    Brad –
    Your post points to the infuriating failure of U.S. economic actors to mend their profligate ways. Usually, the current account acts as a buffer to absorb some of the cyclical changes in aggregate demand. In the present case, this does not appear to be happening. If current fed and government policies lead to a crisis of faith in U.S. government and near-government debt, the result will make the current problems look quite mild. It doesn’t look like we have reached that point yet, but who was predicting the housing collapse in early 2006?

  • Posted by Rien Huizer

    The NAB decision to mark down their (small) CDO provision couls have all kinds of reasons. Australian banks are very profitable but depend also very heavily on overseas funding. Australia is just crawling out of one of the worst strings of current account deficits in it history. Part consumer exuberance, part bussiness capex. A bit like the US, but with two differences: Australia has government supluses and Australia’s corporate sector is heavily foreign-owned. Until recently, the domestic savings deficit was funded by eurocurrency and commercial paper borrowing by the 4 large banks plus overseas placment of …MBS (structured by non-bank mrtgage providers and insured by monoliners). The MBS business is no longer there, so all the weight falls on th banks now. In addition, the big 4 australians are also the main banks (and again current account balancers) of New Zealand. While the Ozzie conomy is in pretty good shape (especially now the Reserve Bank is doing its job by killing the housing marketand thus the consumer’s wealth illusion) and will remain OK as long as China (see next post) remains a volume (and not profit) driven enterprise state, causing the Chinese to buy Australian minerls, foodstuffs etc and causing the inrnational mining industry to continue to expand their investment rather than running it down, the Kiwi’s have very little to cheer about, except fly in fly out jobs in booming Oz.

    Tht explains why highly profitable and well-capitalized, resoundingly too big to fail banks can play strategic games by being the first to write down very aggressively.

    This will benefit the industry which is under severe public pressure to relax mortgage rates (most are variable and traditionally linked closely to the official short tem rate. Due to the global interbank problems that connection is lost and many in Australia (and especially NZ, foreign banks remember) feel that the banks should suffer some margin comprssion due to their obscene profitablity .
    This will depress NAB’s profits nicely, has a non-ongoing cause and may actually turn out to be an interesting investment if and when the market turns around. I do not believe, despite my respect for Mr Kohler (who is one of the more intelligent TV commentator on finance I know) that this mountain of special circumstances will have much effect. But who knows, poorly interpreted events can make devastating news…

  • Posted by Rien Huizer

    The impact on China of a US consumer recession may be 1% less growth (2-3 million jobs growth less ) per 1% less US growth according to the eminent Dr Yu’s associates, and we do not know where that attractive function comes from. It looks like a pretty dodgy statement. The way China’s economic incentives work (growth drives officials’ careers and livelihood), there will be a lot of effort to keep production and expansion going at the expense of profitability if necessary, especially now the corporate sector is cash rich, the banks are flush with money that they cannot lend and capital that could support balance sheet expension. If the leadership -in extremely simplistic terms- had to choose between jobs and banking system health, (probably the populist vs reformer (or whatever label we give the non populists) choice) jobs would win hands down. One of the more important Japanese lessons. Profits are helpful for growth, but not essential in the short run, as long as you have access to cash and labor is cooperative or captive. And your industries have long term viability. One way to achieve that is to kill exhaust your competitors and o course, along the way, the weaker horses in your own stable will be eliminated as well.

    To me it looks like a pretty soun approach. The problems are 20 years down the road, who cares about that. Meanwhile, there is no meaningful US response,and China has given the US populists a little appreciation to show merit domestically. Just imagine what another cycle of bad industrial lending on top of a cycle of speculative lending (ral estate, shares) means for the quality of the newly rehabilitated SOE banks intellectual capital and hence the longer term future of competitive finance (and thus true capitalism) in China. An intelligent approach to China would ignore (relatively speaking, appreciation does no harm) China’s exchange rate policies, bring own house in order and lean on China (if necessary with volume- or category- related import quota’s) on issues like environment, working conditions, higher and better collected taxes (yes, in this case!) and much better provision of collective goods. The leadersip would find that very difficult to respond to. Just imagine Italy (for instances) refusing to buy Chinese made shoes because of poor school building standards in China and public outcry about that in Italy (a sovereign state with a long tradition of dealing with formal obligations creatively) .Services are the only way to boost China’s domestic consumption and create jobs that are inherently less prone to productivity boosts from technology. Who needs Tibet as an issue? If you want to be assertive to China, direct your NGOs to target issues that resonate with the Chinese people themselves, like construction standards, sanitation and schools.

  • Posted by aim

    It is ironic that the governments buying US debt to support their currency devaluation against the dollar (or should I say proping up the dollar) have been damaging the very economy that they are investing in.

  • Posted by Twofish

    McKanlay: The National Australia Bank’s decision to write off 90 per cent of its US conduit loans will have dramatic repercussions around the world. Wall Street will be deeply shocked when they understand the repercussions of what NAB has done.

    No they won’t. People who understand what is going on will look at exactly what they did and yawn. It’s people that don’t quite understand what is going on that will go into “sky is falling” mode.

    Huizer: If the leadership -in extremely simplistic terms- had to choose between jobs and banking system health, (probably the populist vs reformer (or whatever label we give the non populists) choice) jobs would win hands down.

    One thing that I’ve noticed is that sometimes people lose sight of what the goal is. The goals are economic prosperity, and if you make the banks “healthy” but in the process toss people out of work permanently, you have to wonder what the purpose of making the banks healthy was in the first place.

    Huizer: lean on China (if necessary with volume- or category- related import quota’s) on issues like environment, working conditions, higher and better collected taxes (yes, in this case!) and much better provision of collective goods.

    The problem is that this presumes that people outside China are somehow better and wiser at making economic tradeoffs and in generally running an economy than people in China. One lesson of the last set of bank problems is that its not clear that people in the West know how to run an economy better than the people than people in China. Certainly suggestions and ideas are appreciated, but if things start become more than polite suggestions, I do think that China needs to push back a bit.

    China can take care of itself, and I’d much rather people in the West do what they need to do out of pure self-interest than out of concern for people in China. If the United States needs to raise tariffs to protect jobs in Kansas and North Carolina or send troops into the Middle East to protect the flow of oil, I’m fine with that.

    The trouble with mixing self-interest and altruism is that self-interest ultimate discredits any altruism. By trying to link trade and liberal political reform, the West has managed to completely discredit the democracy movement. If the West starts supporting a “earthquake-proof schools movement” through trade pressure and then the Falugong, Tibetan independence people, and labor unions show up to advance their interests, this will destroy public support in China for the ‘earthquake-proof schools movement.”

    I made a point at a discussion about foreign policy toward China where I pointed out that it was very damaging for Western nations to push policies as being good for the Chinese people when it’s pretty clear that the motivation were self-interest. For example, when people bring up intellectual property, ultimately it is because Western companies want to make more money…..

    The speaker replied that Chinese aren’t stupid and can obvious see that the West in these situations is acting out of self-interest, ignore the altruistic coating, reply accordingly. Fair enough…. So when the US government then moves the topic from trade and intellectual property to political dissidents and minority issues then……

  • Posted by Twofish

    AJ: Brad- I wonder if the trigger to adjust will come from an internal crisis in China’s financial system. As Michael Pettis noted yesterday China’s mortgage market actually looks a lot like the US market in 2006 and their financial institutions are even more precarious,

    We’ll see over the next several months, but I’ve had a long standing disagreement with Michael Pettis over the health of the Chinese banking system, and I am much more optimistic that it will withstand a slowdown than he is. In particular, I do not think that Chinese banks generally are more precarious than US banks.

    The basic problem with US banks is that they were able to use securitization to circumvent restrictions on lending and reserve requirements. Chinese banks just weren’t allowed to do this. Yes people in Chinese banks may have tried to circumvent the restrictions on lending, but it makes a big difference if you have to make some effort to circumvent the regulators, than if the regulators are simply not standing in your way.

    One big difference is that Chinese officials have been worried about a banking collapse since 1998 and have been working very hard not to make it happen. By contrast, if you go to 2004-2005, none of the regulators seemed very concerned about the possibility of banking problems, and so the US allowed things that Chinese officials simply did not. For example, there is nothing in China that I can see that corresponds to widespread lending of subprime mortgages or the securitization infrastructure that supported this mess.

    One other difference between China and the United States is that urban wages in China are growing rapidly whereas wages in the US have been stagnant since the late-1990’s. This means that there is much less pressure to extend massive amounts of consumer credit.

    Again, I might be wrong about this and it could be the Chinese banking system is going to collapse in three months. However, if it turns out that the Chinese banking system doesn’t collapse or experience major difficulties in the next year, I think the psychological impact in global politics and economics is going to be profound.

    The assumption that people have is that the US is better than China and so if something is bad in the US, then it is worse in China. If we have a situation in which this turns out obviously not to be the case, it’s going to shake some basic assumptions people have on the way the world works, and as people try to make sense of the new order of things, unexpected things will happen.

  • Posted by Rien Huizer


    Yr # 38. I did not mean that foreign a country (US, EU, hwatever) should lean on China etc to benefit the Chinese.. Not at all! I guess these foreign politicians have have plenty of work with their own people. It is not meant to be altruistic at all. If the Chinese government is pushed by a broad (trade requirements, WTO is nearly dead anyway) selection of trading partner’ trade diplomats and private organizations stop complaining about irritant irrelevancies like Tibet, but use instead the Workers’ Human rights etc, as a theme to justify taking people’s money, this would be a wonderful political tool to make Chinese production less disruptive to world trade and democratic (necessarily populist) potitics.
    All the Chinese gvt has to do to comply is redefine prospertity, by resocializing the economy (trade unions, health care, benefits for injured construction workers without hukou etc. All the wonderful things this Workers’ Paradise once had and lost when the party became a franchise. and once again, I do not care whether the Chinese have these things or not, I just want them to have the drag..And I believe tht there is nothing more treatening to the regime (in the sense of political system) than a bunch of social-democratic features added to laobaixing’s minsheng.. Ideally, the spreading of this gospel should be done by respectable NGOs, who do not derive much of their funding from PRC apparatchiks but rely on all those nice little privte donors whose minsheng is threatened because laobaixing, with his hard work, kid in uni yearning for a pet and a car, is deprived of things they are forced to consume, by western society.

    This idea came up out of frustration with western policies for engaging Cina on the economy, and it looks crazy, but the more I write about it the better i like it. This is how Sweden once got into trouble, why not try it on China? One of the other beauties is that if China does this (also with reference to a long tradition of benevolence, rice growers’ communautarian spirits and the Chinese Zodiac), and the western trading partners will make this a universal requirement, which wll then freeze the enormous development gap between China and countries like India. That the Indians would never be able to catch up should be an added bonus to the leadership, next to the threat of poisoning the Workers’ minds with socialist ideas.

  • Posted by Rien Huizer

    Twofish, to avoid further misunderstanding, I know that there were no trade unions in the Former PRC and that an injured construction worker without a hukou was an imposibility. Just to give an imprssion. And the nice little NGO donors are, of course in the west (or east for that matter). I recommend Mao’s “On coalition government”. One of the more astute political works I’ve ever read and, despite the rhetorical flourishes, brief.

  • Posted by Howard Richman


    You are correct that the worst is yet to come. We are just in the second stage of a three-stage mercantilist-produced collapse.

    During the first stage (from 1995 to 2005) the mercantilist government loans lowered our interest rates causing our asset values to go up. We felt rich and were able to borrow for consumption and for house and mall construction. The foreign money pouring in enriched our financial industries. We closed our eyes to the fact that we were losing about 20% of the our manufacturing jobs while investment was stagnating in our trade-competitive sectors.

    During the second stage, which we are now in, our lack of past investment in our trade-competitive sectors, such as manufacturing, is causing the dollar to decline. Foreign governments, and it’s not just China, have been increasing their dollar purchases to keep their currencies undervalued relative to the dollar while at the same time they maintain other barriers to our imports including tariffs as well as artificial barriers, such as the Chinese prohibiting the riding of Harley Davidson-size motorcycles on many of their roads.

    The mercantilist countries, especially China, will continue to finance our trade deficits while they steal our remaining industries. China is currently working on getting US market share from the following industries:

    1. Currently the Chinese government is financing the purchase of GE Appliance to get GE’s market share. After that purchase, they will close many US factories.

    2. Currently tariffs and other barriers in the growing markets of the world have put our vehicle parts and vehicle production industries on the ropes. If nothing is done, it is quite likely that GM and Ford will go bankrupt.

    3. Airbus is moving its production to China which should allow China to steal our aircraft production industry.

    4. China is building 3 factories to compete with our heavy mining equipment companies, including Bucyrus, while protecting their new industry behind both a currency-manipulation barrier and a tariff barier.

    More and more governments are voluntarily participating in these dollar purchases. (After all, it is not often that a country voluntarily gives away its productive resources!)

    This stage will not end until China has finished stealing our remaining industries. The US trade deficit will continue to increase even while the dollar gradually falls.

    The third stage will commence at the time that China chooses to start selling their dollars. My guess is that it will occur approximately one year before China challenges the United States over Taiwan. At that point, China will prove David Chiang’s statement in comment #17: “The real winner from the Cold War was’t the United States. – DC.”

    The third stage will leave the United States in poverty with a collapsed currency, high interest rates, and high inflation. It will leave China as the dominant economic and political power in the world.

    As we note in our book, “Trading Away the Future,” it is not too late for the United States to avoid the impending collapse. The United States still has enough industry left to build upon, should we take action now. If we wait ten years, then it will be too late.

    All we would need to do now is to insist upon balanced trade with our mercantilist trading partners. The result would be a huge increase in investment in our remaining industries. America would resume the path toward prosperity.

    Howard Richman

  • Posted by Twofish

    Huizer: All the Chinese gvt has to do to comply is redefine prospertity, by resocializing the economy (trade unions, health care, benefits for injured construction workers without hukou etc.

    The trouble with this is that running an economy isn’t a matter of waving a magic wand. If you have more health benefits for workers, that means that the things to fund that have to be taken out of some other part of the economy, and whoever you take it from may end up being upset, and once you look at the details it turns out some of the things you think will help don’t.

    For example, it turns out that giving construction workers urban residency isn’t that useful to them since in getting urban residency, it means giving up rural residency which is serves as something of an insurance policy if somethng happens to them in the city. If they get urban hukou, then they start paying for social services and pension funds that they are very unlikely to use since they want to return to the country if they get sick or old.

    If you read field reports from anyone that has been in the trenches, you find lots of other examples of things you think are good ideas that don’t seem to work, or things that you think are awful ideas that work well.

    So all of these well meaning prescriptions might end up either useless or make the situation worse. A bureaucrat in Beijing is has enough difficulty figuring out what construction workers in Tianjin want. A bureaucrat in Washington DC is even much less likely to figure out what is useful to Chinese construction workers. He, however, is much more likely to know the needs of American construction workers.

    Personally, I think everyone would be better off if American politicians just tried to represent American workers and not try to “do good” for Chinese workers. I also cannot understand the psychological block that makes American politicians afraid to admit the truth which is they they are being selfish.

    Huizer: This idea came up out of frustration with western policies for engaging China on the economy, and it looks crazy, but the more I write about it the better i like it. This is how Sweden once got into trouble, why not try it on China?

    Can you explain to me what you are trying to do here?

    Anything that raises worker expections to levels that the political/economic system cannot satisfy which then creates a collapse in the political/economic system is a very, very bad thing.

  • Posted by Twofish

    Richman: The third stage will leave the United States in poverty with a collapsed currency, high interest rates, and high inflation. It will leave China as the dominant economic and political power in the world.

    China has no chance of being the dominant economic and political power of the world any time in my lifetime, and there isn’t any particular desire among most Chinese right now to be the dominant power in the world.

    Even if the US collapses, India, Russia, and Japan will keep China in check. Without a US presence in East Asia, both India and Japan is likely to have 200 nukes within a year and this is very unlikely to be in the Chinese national interest.

    Richman: The United States still has enough industry left to build upon, should we take action now. If we wait ten years, then it will be too late.

    The problem I have is that I don’t think that your assessment of what is wrong with the US is correct. What I’m afraid will happen is that the US will spend a decade or two “blaming China” for everything that is wrong with the US, and this will waste time. I don’t think that it is China’s fault that the US doesn’t have a rational health care system or that unfunded social security system, or a regulatory system that led to the subprime mess.

    Part of my outlook comes from seeing the mistakes of the Cultural Revolution. From about 1949 until 1978, China blamed “evil US imperialists” for everything wrong in China. Every bad thing that happened was the fault of the neo-colonialists and Western powers. Things really didn’t improve until people just stopped blaming the US for everything.

    Part of the political reality that you are ignoring is that people in the US want cheap Chinese products and loans. If there were a US national consensus to do something about the trade deficit, it would get done. The trouble is that there isn’t, since you have large numbers of Americans that are benefiting from the trade deficit. As long as you can’t provide them a reason why they should care about the trade deficit, they won’t.

    Now claiming that China has this evil grand conspiracy to take over the world and enslave Americans, could get people to care, but it has the major flaw of being not true.

    There ***is*** something of a grand conspiracy to make China a rich and powerful country. I am a part of that conspiracy, and the discussions that I tend to get into are “what can we learn from the United States to help the Chinese financial system” rather than “how do we destroy the United States.”

    If anything the discussions tend to be able how to avoid conflict with the United States, since anything that causes the US economic and military to collapse is going to cause many, many, more problems for China than it resolves.

  • Posted by Twofish

    Huizer: That the Indians would never be able to catch up should be an added bonus to the leadership, next to the threat of poisoning the Workers’ minds with socialist ideas.

    Let me ask you a silly question. Why should it be in China’s national interest if India remain poor? This isn’t a game in which what is bad for you is good for me.

    The US has this weird insecurity about having to remain number one in the world, and it looks at China and assumes that China also wants to be number one and displace the United States as the global superpower, which isn’t true. China certainly wants to be a great power and a rich and powerful nation, but unlike the US that has this urge to make everyone in the world adopt its system of government, China couldn’t care less what how the government of Mexico is set up.

    The only person I know of who was born within the current borders of the PRC who is trying to spread some sort of universal political ideology is the Dalai Lama.

  • Posted by anon

    bsetser – a variation on your theme is that funding of the US external position is too concentrated to persist in its current form. Foreigners in aggregate have no choice but to fund the US requirement at some level of exchange rates and asset prices. But further geographic redistribution of funding share is possible. Concentrated funding sources like China, Japan, and the Gulf could diversify their currency asset mix further by selling Treasuries and dollars to other foreigners, in exchange for 3rd currency foreign positions. In fact, for foreigners in aggregate, this is the only way in which they can effectively adjust the intensity of their existing asset exposure to the US, ex valuation adjustments or absent an outright reversal in the US current account imbalance.

  • Posted by flow5

    Howard Richman: I have to believe that you are exactly correct.

    This was predicted in June 1980: The growth of FNMA & other governmental and quasi government agencies was the direct result of the DIDMCA of March 31st 1980. The Act provided the legal basis for the addition of 38,000 commercial banks to the 14,000 we already had, and the abolution of 38,000 financial intermediaries. Economists don’t know the difference between banks and non-banks.

    From the time Greenspan changed to an “easy” money policy (1/31/01), until the time it ended, the expansion coefficient (money multiplier) almost doubled. I.e., legal reserves are no longer binding. Thus, regardless of the “policy formula” used, the math projected a much “tighter” monetary policy than what actually took occured.

    I.e., one dollar of legal reserves in 2007 had twice the legal-economic punch as legal reserves did in 2001. Therefore the Fed lost control of the monetary aggregates (bank credit – loans-deposits).

    Free-gratis legal reserves, as contrasted to liquidity reserves, are a necessary requirement of all money creating institutions, with the exception of central banks. Barring the necessary legal restraints, these institutions will create an excessive volume of money. Barring direct authoritarian controls, the only method by which the volume of money can be properly regulated is through central bank control of commercial bank free legal reserves and reserve ratios (the minimal ratios of legal reserve assets held by the commercial banks to their deposit liabilities)

    To be effective, the free legal reserves of commercial banks must be confined to a bank asset that can be constantly monitored and controlled by the monetary authorities. Only Federal Reserve Bank inter-bank demand deposits (FRBIBDD) meet this condition. The volume of FRBIBDDs is almost exclusively related to the volume of Reserve Bank credit. That is Reserve Banks acquire Treasury Bills, etc., by creating IBDDs – the free legal reserves of money creating institutions.

  • Posted by Charles

    Brad, the real worry is that the government has spent the first three innings of the mortgage crisis ineffectually spending money and not much else.

    Citizens for Tax Justice, a generally pretty reliable source on tax issues, is very skeptical about the housing bill. There are some block grants that will help localities deal with the costs of dealing with foreclosed properties, and about $15B in help to homeowners and builders, but CTJ thinks it’s structured such that it may not really help. In any event, it’s a few billion dollars for a trillion dollar problem.

    By next January 21st, the crisis may have ripened past repair.

  • Posted by anon

    bsetser – some large numbers are being bandied about for the exposure of the US government to potential GSE losses. These exposures could result in Treasury’s recapitalization of the GSEs, with related requirements for additional government bond financing. Since this is a balance sheet issue, it isn’t really correct to categorize this additional financing requirement as an incremental government deficit, is it? It’s more comparable to the Fed making another financial investment and sterilizing it, except this will be done on Treasury’s books. In fact, won’t this technically improve the ‘quality’ of US government debt at the margin, because it represents a claim on a financial asset as much as on future taxes?

    anon 1:26 p.m.

    anon 1:26 p.m.

  • Posted by Rien Huizer


    My suggestions -impracticable, the Us would never be able to execute this- were not meant to be “good for the Chinese people” I have no idea of what is “good for” any people (though when I was young that used to interest me, but as I grew older I realized that this was just Greek philosopy nonsense) I was just thinking as a mechanic how to solve this structural imbalance in a way that is good for US politicians and might just keep the apparatchiks in Beijing in power (they must e aware (LKY must have told them a thousand times) social democracy would wreak havoc with their support base, even more than, say, Korean democracy (The Korean elite has learned how to live with and developed tactics for their variety very quickly). Hence, planting and nourishing it a bit (more or like the extremely successful “Human Rights” in the cold war) is an extremely cheap way of undermining your opponent. And a cause for NGOs that is both worthy and useful. And it makes the common folk at home feel good as well.They might even start to prefer a US economy that is a little more difficult for the current generation of predatory interests (defense, finance and healthcare) and pave the way, politically for different ones (low cost high impact defense, universal health insurance, aggressive consumer movement etc).
    Now, given the fact that the ex-Comrades are historically aware, they will immediately recognize this as a signal that the US is taking them seriously and no longer treating them as cartoon characters and what German marxists used to call “nuetzliche Idioten” (useful idiots), who toil day and night to keep US consumers happy and inflation low, all the while without getting paid.

    The carrot for the PRC leadership would be that the competition in their rear (I am convinced that the populists (not the reformers) believe in a zero sum world, it is the only world view consistent with populism (In One Country) is locked up. Of course somewhere along the line there will be cheating hence my happy world will not last more than a few decades, but, the threat of social democracy is a very powerful one. Pity the US is not organized to execute this. It could keep BW II alive, Japan stationary, educate peasant children in China and urban kids in Cleveland illiterate..

    Just to be absolutely clear, all of my comments here were merely to illustrate that the problem under discussion has no non-oddball solutions (and in return I learned that some people are serious and constructive even in the face of unavoidable disaster caused by human stupidity (prefer Sophocles to Plato any day, Twofish, no Hidden Dragons there, unfortunately). It could have ben avoided only three years ago, if Mr Greenspan and his buddies in the Treasury had ben a little more responsibe and stayed out of weird, expensive international contests. That would have delivered mr Kerry to the White House Hmmmm. But that is history.

  • Posted by Rien Huizer

    Just this little gem from n expert:

    And, not a word about Central Huijin. If this has a base in fact, then CH would be in the wrong place of course. If CIC is a bank holding company, it is not the ideal vehicle for international portfolio investment either. And if it is really an internationally oriented portfolio investor a la GIC, it is no better positioned for BHC-ship than the POBC. Let’s liberate Central Huijing!

  • Posted by gaius marius

    as to what might end foreign central bank credit to the united states — i see some here dismissing the possibility and others considering that it would take a crisis inside china.

    has anyone considered that it might simply be in china’s interest?

    it addresses both inflation and hot moeny problems. much is made of the forex losses china would assume — but the increased purchasing power of the yuan would likely offset these losses in diminished transfers for oil alone. the pain in the export sector would be considerable — but would also be a necessary change, as china is already no longer the low-cost producer for low-end exports. china is moving to more sophisticated exports where it has no natural competitor on volume and price (eg technology, cars) even at higher currency levels, reducing the pain of the change. and there’s also to consider the benefits of becoming a reserve/international transaction currency under a free float.

    we tend to think that the larry summers’ ‘financial balance of terror’ can’t be broken voluntarily, but i would submit that the stage is set for just that — if china’s leadership has the courage to make the move.

  • Posted by Rien Huizer

    Gaius Marius,

    Yes, It tends to cross one’s mind but it would be quite painful, not in line with China’s “transition” (the wrong term by now, it is taking forever). It is even harder to think through the posible scenarios for that than what would happen if “change” was postponed until say 2012, when a determined US should have been able to pss trough the downturn and get used to more difficult credit, lower house prices (say the equilibrium prices you will find in the most recent IMF WP, take your pick as to what kind) and a much tighter federal budget. By then the USD should be at about the current level of purchasing parity, after possibly have gone through a dip. A grat time to say BW II farewell, without too much damage to either partner. From then on, the US will be more of a normal country and China too. Not a bad prospect, but an unlikely one.

  • Posted by Twofish

    Huizer: (They must e aware (LKY must have told them a thousand times) social democracy would wreak havoc with their support base.

    What ultimately should keep the Chinese leadership in power are policies which improve the livelihood of the Chinese people. If the economic interests of the Chinese people are not in the economic interest of the Chinese leadership, then we need to think about changing the system so that they are….

    As far as what policies will increase Chinese prosperity, we just don’t know. Maybe social democracy is a good idea. Maybe it’s a horrible idea. Most likely it’s an idea that may be good or bad depending on the details. LKY is smart, but he could be wrong.

    Huizer: I am convinced that the populists (not the reformers) believe in a zero sum world, it is the only world view consistent with populism (In One Country) is locked up.

    I’m not. One has to be careful not to oversimplify what people believe. The populists are much more suspicious of the market than the technocrats, but no one I know thinks that market economies are fundamentally flawed.

  • Posted by Twofish

    Charles: in help to homeowners and builders, but CTJ thinks it’s structured such that it may not really help. In any event, it’s a few billion dollars for a trillion dollar problem.

    Keep in mind that it’s probably not in the political interests of people to make the real price tag apparent.

  • Posted by bsetser

    Michael McComack isn’t the only one to ignore Huijin/ the banks. Lou and Gao’s public comments to the effect that the CIC never takes controlling stakes are very similar. I also doubt that the world is going to be comfortable with even a pure portfolio managing CIC that reports to the state council if another entity under state control is aggressively supporting the outward expansion of China’s firms.

    Gaius Marius — I take the risk that China would redefine its interest as “not losing any more money on the US dollar” very seriously. There are some inside China who think the current policy isn’t in China’s interest. The data so far though suggests that they don’t drive policy; China right now seems likely to slow the pace of RMB appreciation.

    Rien –my (tentative) approach to China would be the opposite of yours, namely it would prioritize the exchange rate relative to other goals.

    This is because:

    a) the exchange rate defines China’s relationship with the rest of the world, and thus has more obvious spillovers than domestic policies (tho I concede the environment now has large spillovers)

    b) the exchange rate not only shapes China’s monetary policy, but increasingly its fiscal policy (now used to fight inflation in the absence of monetary policy, and in the process, push china’s savings up) and its bank policy (bank loans curbed, high reserve requirement, banks holding fx, etc)

    changing china’s exchange rate (gradually) isn’t obviously in the interest of all parts of the US economy — big swathes of the economy (and corp america) benefit from cheap imports/ cheap borrowing. others don’t.

    I do tho think adjustment is in the US interest. I wouldn’t frame this as “doing what is good for china” for the reasons 2fish articulates. I would frame it as doing what is necessary to be a good citizen in the existing global economic and financial system.

    big exporters historically haven’t intervened to China’s tune on a consistent way — either china changes, or the rules of the game have effectively changed.

    Moreover, 20% growth off a $1.5 trillion base isn’t possible. i am not sure sustained $250b export growth (pushing exports to $2.5 trillion at the end of 2012) is possible.

    And I am sure that sustained $500-1000b of government foreign asset growth will change the world — it implies a much higher level of state ownership of US industry than America has found comfortable, and if not US industry, then European industry.

    Those who talk of avoiding financial protectionism are I think doing China a disservice, as they may be giving China’s leadership hope that the sale of $2 trillion of US stock to China (or less — take your pick on China’s foreign asset growth on current trends, and the share that goes into “risk” assets now that China has more treasuries and agencies than it needs) is politically acceptable. My guess is that it isn’t, even if it goes mostly through third party intermediaries.

    Basically, China has to change if it wants to be an accepted part of the global economic system, as its current course isn’t consistent with global norms. If china believes that the world’s norms should change to accomodate its exchange rate regime andits desired buildup of foreign assets, it then needs to make the case.

  • Posted by Dave Chiang

    Unfortunately, Obama was on “Meet the Press” this morning, and he said he has brought Rubin and Sommers on as part of his his financial advisor team. These are the guys who gave us the repeal of the Glass Steagall Act and pushed derivatives. McCain has Phil “no whining” Graham, the author of the bill that repealed the Glass Steagall Act. “Clowns to left of me, jokers to the right, Here am I, stuck”.

  • Posted by Dave Chiang

    A mandatory weekly read.
    “A GSE Perspective”

    From Doug Noland

    “For some time I’ve viewed these institutions as the key linchpins for a historic Credit Bubble along the lines of John Law’s eighteenth-century Mississippi Bubble. The GSEs, with their implied government backing, forged a fundamental – and momentous – change in the nature of contemporary “money” and Credit. Their financial and economic impact has expanded exponentially since their initial foray into system liquidity backstop operations back with their 1994 bond market/hedge fund “bailout.” I am left to scoff at the CBO’s $25bn estimate for the likely eventual cost to the American taxpayer.

    When I read the various estimates of the GSEs’ additional capital requirements, I again reflect back to one of the great flaws in economic historical revisionism with respect to the Great Depression. Conventional (“revisionist”) thinking today has it that if the Fed had simply “printed” $5bn and replenished lost banking system capital in the early thirties, the worst effects of the depression would have been avoided. But then, as is the case today, the size of lost financial sector “capital” was not the critical issue. Instead, financial sector losses pale in comparison to the huge scope of additional Credit creation necessary to sustain deeply maladjusted financial and economic structures – and the impossibility of sustaining Credit Bubble excess in the face of escalating risk intermediation losses and resulting tightened financial conditions, sinking asset prices, acute financial system impairment, investor and speculator revulsion, de-leveraging, major changes from boom-time spending patterns and economic downturn.

    Treasury and the Fed could today easily “cut” Fannie and Freddie (and the FHLB!) a $20bn check or, ok, $50bn. Yet the reality of the situation is that GSE “Books of Business” must expand at least $600bn this year and then as much next year and the year after that… or very serious problems will unfold throughout the conventional mortgage marketplace. There are Minskian “Ponzi Finance” dynamics at work here, as there were in subprime, “private-label” MBS, CDO, auction-rate and other markets. Only the stakes of a conventional mortgage bust are much greater.

    Without the GSEs, there is no way Total U.S. Mortgage Debt would have doubled in the six years 2001-2006. Without the GSEs, it would have been impossible for broker/dealer assets to have ballooned from $455bn to begin 1995 to $3.10 TN to end 2007. And I believe very strongly that without the GSEs the leveraged speculating community would be but a fraction of its current unfathomable size.”

  • Posted by Simon

    This is an amazing dialogue!! A privilege to read.

  • Posted by Rien Huizer

    Brad, my advice to China would be the same if I were acting in what I would believe are their national interests. But national interests are subjective (and contingent upon many things) and trade can be cooperative or competitive. Many Asian countries (pick up any government sponsored work on Singapore’s economy and it is full of Michael Porter stuff). If China and the US cannot agree on something more balanced and if one or either party works against the market (even if in the opportunistic interests of politicians on both sides during the past four years (I guess most would agree that Chinese funding and low inflation/pressure on US wages were convenient for the current adminsitration, and export-generated employment for the Chinese) then it makes sense to find out what sorts of things could crate leverage in a low cost way when the consensus breaks down, as, I am sure it has meanwhile. The oddball idea of sowing social democracy was inspired by the brilliant use of human rights by the US in WWIII, something which the Chinese leadership will be keenly ware of. But, again, in economics terms, you are right of course.

  • Posted by Dave Chiang

    US Banking System Is Unsound

    From Mish Shedlock

    The US banking system is unsound. I presented the case in You Know The Banking System Is Unsound When….

    Of the $6.84 Trillion in bank deposits, the total cash on hand at banks is a mere $273.7 Billion. Where is the rest of the loot? The answer is in off balance sheet SIVs, imploding commercial real estate deals, Alt-A liar loans, Fannie Mae and Freddie Mac bonds, toggle bonds where debt is amazingly paid back with more debt, and all sorts of other silly (and arguably fraudulent) financial wizardry schemes that have bank and brokerage firms leveraged at 30-1 or more. Those loans cannot be paid back.

    What cannot be paid back will be defaulted on. If you did not know it before, you do now. The entire US banking system is insolvent.

  • Posted by Dave Chiang

    Latest from Bill Fleckenstein

    Of course, the fantasy has friends in high places — namely the Fed, the Treasury and Congress, which last week engineered a huge bailout for Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), though Treasury Secretary Hank Paulson has tried to insist it won’t be needed. Never mind what this portends for our economy — Wall Street applauded legislation many of us find repugnant.

    The government’s efforts will not create a bottom for financial stocks because of the fundamental problem in this country: People carry too much debt against homes that are sinking in value, homes they really couldn’t afford in the first place and homes that have become all the more burdensome due to the inflation that’s ravaging their paychecks. That the implosion of the housing debt bubble is dragging the economy down with it will just put additional pressure on jobs and the ability to service housing debt.

    Exhibit A: American Express (AXP, news, msgs). In last week’s earnings release, the company noted that it has now been hurt by the weak economy. AmEx described the weakness as much worse this quarter than it had been in January and said it expects that trend to intensify.

    AmEx noted that even some of its “superprime” card members are feeling the effects of the weak economy. Of course, if AmEx’s customers are having problems, you can be sure that virtually every credit card company is seeing its consumers struggling to pay their bills — despite help from government rebate checks.

    The Fed’s money-printing apparatus has been checkmated by roaring inflation. None of Paulson’s cockamamie schemes, from super SIVs to bailing out Fannie and Freddie (after Bennie and the boys at the Fed bailed out Bear Stearns), will help the economy. Yet we must continually endure the cheering by stock market operators every time this country, the supposed bastion of free enterprise, “successfully” takes another step in its move to nationalize all losses that are inconvenient to those in power. As Jim Grant questioned in a brilliant Wall Street Journal article July 19, “Why no outrage?”

    That is a truly disturbing prospect because the same incompetence and greed that brought us this mess will lead to further troubles if the cabal that surrounds Fannie and Freddie gets more powerful, which appears to be the case from the legislation just foisted on U.S. taxpayers.

    To Paulson, one of the cabal’s powerful members, who last week described the legislation as sending “a very strong message to the markets,” here is my interpretation of that message:

    Yeah, we’re willing to do anything to keep the status quo, as rotten as it is, because reform is too painful to contemplate.

  • Posted by Olkon

    Russia cuts exposure to US mortgage lenders –
    28 July 2008
    Provided by: Reuters News

    MOSCOW, July 28 (Reuters) – Russia has approximately halved to less than $50 billion its exposure to U.S. mortgage lenders Fannie Mae and Freddie Mac , a senior central bank official told Reuters on Monday. “It’s now less than $50 billion,” central bank first deputy chairman Alexei Ulyukayev said, when asked about Russia’s investments in the agencies.
    Russia held about $100 billion at the start of 2008. (Reporting by Yelena Fabrichnaya, writing by Robin Paxton)

  • Posted by Andy

    Great article and I just wrote about my views on the recent housing bill. Your points just conifrm why the housing relief bill will fail. The government again is trying to spend us out of an economic crisis because we and our institutions are too big to fail. The bill is unlikely to work and only add to our national debt and the continued devaluation of the US dollar. Only time and a cleansing of the economic system will resolve the current mess.
    We talk about consumers getting out of debt, what about the government who seems to love debt more than anyone else.

  • Posted by RealThink

    In comment #5 above, I argued that the key point was: “What should the US do with the external financing while it lasts?”, and that the best path for the US would be to let mortgage financing dry up and homebuilding in its current form come to a screeching halt, and employ its labor and (ever more scarce) physical resources in a massive wind farm construction plan like Al Gore proposed recently.

    A recent post from Dave Cohen, one of the sharpest Hubbert’s Peak-aware analysts greatly strengthens this case.

    Dave points out that today a wind farm construction plan of that scale is simply unfeasible because of PHYSICAL constraints, those of steel production being the foremost.

    Which adds further support to the case for bringing suburban McMansion construction to a screeching halt. Like in WWII, when residential construction and car production were stopped to direct all resources to the war effort. Sure enough, 100% of electricity from renewables is unfeasible, but the higher percentage that can be achieved, the better.

  • Posted by bsetser

    interesting article re: Russia — thanks for bringing it to my attention.

  • Posted by Twofish

    bsetser: Basically, China has to change if it wants to be an accepted part of the global economic system, as its current course isn’t consistent with global norms.

    At this point China has enough financial leverage to play a part in setting global norms.

    bsetser: If china believes that the world’s norms should change to accomodate its exchange rate regime andits desired buildup of foreign assets, it then needs to make the case.

    Make the case to whom? As long as the rest of the world accommodates Chinese behavior that the defacto global norm is that what China is doing is OK.

  • Posted by RebelEconomist


    I agree (for my version of the argument see It’s not how big your current account deficit is, it’s how you use it!

  • Posted by david_in_ct

    windpower is unnecessary and peak oil is actually going to be peak oil demand because prices have let in vast amounts of competition. 20 years from now oil is going to be worth a very small premium to the lifting cost of the cheapest wells.

    Gasoline Car Math:

    Current US Car fleet is about 250 million vehicles about 60% passenger cars and 40% light trucks, SUV etc.

    Fleet fuel mileage is about 20MPG

    Total Vehicle Miles Traveled per year ballpark 2.8 trillion (The gov published vehicle miles traveled for trucks buses and car and this is around 3 trillion per year so I knocked off some to get to cars)

    Total gasoline 390 million gallons per day. (per EIA rounded up actual is less now)

    At 20 MPG 7.8 billion miles per day or 365 * 7.8 = 2,847 billion miles per year which is around the estimates from the DOT vehicle miles per year.

    GM volt math:
    The first 40 miles of driving per charge is on the battery so no gas.
    It takes 8KWH of electric to fuel the battery to this level. (the Imiev claims a distance of 100 miles from the same charge but is a much smaller and less powerful car and perhaps not big enough so will stick with the more conservative GM claim)

    Operating Cost Comparisons:
    Current cost at 20MPG and $4 gasoline is 20 cents per mile.
    At 10 cents per KWH (average US retail price) 40 miles is 80 cents or 2 cents per mile.

    Energy Efficiency:

    1 KWH (kilowatt hour) = 3.6 MJ (mega joules)
    .2 KWH = .72 MJ = 1 mile traveled in Volt
    1 Gallon Gasoline = 132 MJ per gallon
    6.6 MJ per mile in gas car
    6.6 / .72 ~ 9 times more efficient energy use in Volt than average car

    Electrical energy needed to replace 100% of vehicle miles assuming all electric:

    7.8 billion miles per day * .2 KWH / mile = 1.56 billion KWH per day

    1GW Power plant produces 1 million KWH per hour or 24 million KWH per day. Put in some down time and you get maybe 20 million KWH per day. Leaving out peak effects it would required about 80 1GW Power Plants to provide enough electrical energy to fuel the entire car fleet assuming it ran on battery power.

    Power Plant Costs:
    AP1000 (Westinghouse) $1.4 per watt to build (ex regulatory madness) So ballpark $100 billion dollars (few months in Iraq so a no brainer)
    Average US operating Costs per nuclear KWH is 2 cents. Of the 2 cents .5 cents is fuel with .2 of the .5 cents being actual uranium cost.

    So the math is pretty straight forward.
    If you electrify the US car fleet you cut oil consumption nearly in half.

    If you simply replace existing cars at the new car run rate it would take about 8 years to replace half the fleet though in reality newer cars are driven disproportionately more to older cars so you would probably replace significantly more than half the gas usage if you replaced half the fleet.

    There is very little that actually needs to be done to get this going. The battery technology exists and will only get better. The power generating side also existing and it too is getting better (Westinghouse has announced plans for a 1.7 GW version of the AP1000)

    The only real impediments to this process are political. If this was outlined clearly to the American people I believe it would take on a life of its own especially if the car production was moved onshore. If I was running someones political campaign this would be my sole platform. If we cut our oil imports by 9 million BPD over the next 10 years a lot of our foreign policy will take care of itself.

    BTW, taken to conclusion around the world this will also end greenhouse gas emission and the whole global warming problem.

  • Posted by Judy Yeo

    Apologies in advance, pooped over for a quick visit and could only read the post and not most of the comments, any repetition of points already made is unintentional.


    Could the preferred mode of action be protection of the status quo; stasis based on not rocking the boat so no one has to face the possibility of getting wet?

    As for the question of why the USA got the help which the emerging markets didn’t – let’s think about it; invrestors pulling out of the emerging markets kaputt could invest elsewhere considering the relative damage of a domino effect was relatively small compared to the tidal wave the world faces shopuld the USA go belly up- bit like Ahab watching Moby. Schadenfreud takes second place to prsactical concerns, crash and burn is bad for everyone.

    Make the case to whom? As long as the rest of the world accommodates Chinese behavior that the defacto global norm is that what China is doing is OK.

    Hmm, the moral of the story could well be – don’t annoy the creditor?


    aah, but deficits are a troublesome thing. The problem is that to finance a deficit you have to find a fool with deep pockets but fools are a dying breed. This means that when you find a fool, you are effectively “locked in”, much like microsoft software (sorry, that was hard to resist!) – to maintain that source of finance, you can’t use that $ in ways that will effectively hijack your creditor’s existing investment- not being able to save your creditor’s investment asset is very different from deliberately sabotaging them.