Brad Setser

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Cross border flows, with a bit of macroeconomics

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The quiet bailout continues ….

by Brad Setser
August 8, 2008

The big financial story today is the dollar’s rally

The dollar fell when oil rose, and now it is rising as oil falls.

Plus, a couple of the key factors that have supported the euro against the dollar — the ECB’s tightening bias and Europe’s resilience (and specifically Germany’s resilience) in the face of the US slowdown — seem to be withering away. I agree with John Jansen: this is more a story about incipient weakness in Europe than strength in the US. Only yesterday US Treasuries rallied (i.e. yields fell) on the back of bad US news.

A dollar rally is one way for the RMB to strengthen against its largest trading partner — though at the end of the day, the RMB needs to strengthen against both the euro and the dollar to help reduce the world’s imbalances, not just to strengthen against one or the other.

Most of the data I follow looks back not forward — even the weekly custodial data reported by the New York Fed. I though was struck by the strong increase in the Fed’s custodial holdings (money the New York Fed holds for foreign central banks) last week: Total custodial holdings were up $24.5b, with a $25.6 increase in the Treasury holdings and a slight $1.0b fall in custodial holdings of Agencies.*

The $24.5b weekly increase is almost as large the $29.1b increase in July. And the $25.5b in Treasury purchases isn’t that much smaller than the roughly $35b sovereign funds have invested in US financial institutions.** It is a huge number.

Right now there are only three countries adding to their reserves at a rate than could explain this kind of growth: China, Russia and Saudi Arabia. Of course, a large country that isn’t adding to its reserves could also shift funds over to the New York Fed, increasing its custodial holdings in the absence of an increase in its overall reserves — but I suspect that at least one of the countries now adding to its foreign assets at a rapid clip is making heavy use of the New York Fed’s custodial accounts.

And it is striking that all the increase went into Treasuries. Treasury Secretary Paulson is in Beijing for the Olympics. I would be a bit surprised if he also doesn’t swing by SAFE and explain how the US government plans to backstop the Agencies

* This is the change from the July 30 to August 6, not the change in the weekly averages.

** I haven’t updated by calculations for the latest Merrill recapitalization, so I don’t have a precise number. The total before the last Merrill recapitalization was $31.4b. This number also excludes the money sovereign funds have invested in European institutions like UBS and Barclays.


  • Posted by tyaresun

    Some one writing on the Traderfeed blog “predicted” this a few days ago. His claim was that this was agreed upon (no ECB rate increases and rate reductions by Aus. and NZ). He said this is the new Plaza accord. Any thoughts?

  • Posted by tyaresun

    Actually it is from Radom Roger’s Big Picture
    A New Accord
    David Andrew Taylor

    It was 1985 when world finance ministers from the G5 (then just France, Germany, Japan, the United Kingdom and the United States) led a coordinated effort to devalue the U.S. dollar. It was known as the “Plaza Accord” because it was signed and agreed upon at the Plaza Hotel in New York City. The idea was to lower the value of the USD vs. its trading partners to reduce the United States’ trade deficit, and to pull the economy out of a deep recession. The Accord was a planned and systematic approach to revaluing the dollar in order to make American exports more competitve.

    Some 20 years later, it appears the world’s finance ministers have converged to change the value of the USD à la the Plaza Accord all over again.


  • Posted by tyaresun

    Oops. Apologies, I thought I had only copied the first paragraph.

  • Posted by mark turner

    Excellent sleuthing, Brad. If it is China (and maybe you’re being timid about shouting it loud, but I’m less so), it also means there’s an endgame. China gets its lower commods prices to re-start its growth cycle (as laid out in its recent politburo meeting and reported by Morgan Stanley).

  • Posted by bsetser

    i don’t think there was any coordination. European growth slowed, and Trichet sounded dovish after a long period of hawkishness (that last rate hike doesn’t look so good … )

    the backdrop was favorable, as the US started to worry that dollar weakness was feeding into inflation — but that was true before this week as well. the catalysts was bad data in europe + trichet (in my view)

  • Posted by Rien Huizer


    Guess so too. More unwinding of orivate positions than oficial activity. But there could be something in the making. At least the Euro seems fairly valued for a moment. Now the Yen!

    Incidentally, it is highly unlikely that something as drastic a a “new Plaza accord” could emerge under the lamest duck administration since Carter. Unless there was an acute crisis, but that may have ben avoided for the time being. Next year maybe, if the underlying situation is still probelmatic.

  • Posted by RebelEconomist


    You say “Of course, a large country that isn’t adding to its reserves is shifting funds over to the New York Fed”. I may have missed something (“of course”?) because this is news to me. Care to say more? Why do you think it is happening?

    There are certain advantages of holding securities at the Fed that I can think of:
    (1) No custody charges (especially since it became possible to allow your bonds to be lent out of the Fed by an specialist agent anyway)
    (2) Confidentiality from the market (unless you do employ a lending agent)
    (3) Later deadlines for some operations.

    By the way, if I have missed something here, it might be because I increasingly skim-read it because some of the comments go on a bit and cover the same old ground. I applaud your edits in the last couple of days.

  • Posted by A. P. Simkin

    Dr. S!

    Is what has happened to the dollar and the euro possibly a result of a reversal of monetary policies? It’s clear the Fed’s been draining reserves since June, as shown in the H3. The oil price fell, and now the dollar strengthens. Did Trichet’s talk indicate that the ECB has started to push some liquidity into their system? Your comments, please.

  • Posted by Judy Yeo

    Whatever the bad press about the Fed’s “solutions”, it seems to have made a good enough impression for the ECB to essentially replicate certain features (Mr Pritchard highlighted a couple in his blog post in the telegraph earlier in the week).

    hmm, when you can’t think of a solution…


    Confidentiality from the market (unless you do employ a lending agent)

    aww, and after all that talk about increased transparency, glass houses anyone?

    BTW, at the risk of sounding like a male-bashing feminist, people might like to take a look at an editor’s comment in the telegraph earlier this week – wonder how many fund managers have joined the boohoo brigade?

  • Posted by theeconomicfractalist

    Dollar Denominated Asset Reequilibrium And the Real Economy

    Profound rotational valuation changes in the US dollar index, commodities, equities, and quality debt instruments will occur over the next 19 or so months. Gold is likely to be revalued at less than 250 US dollars. All revaluations will occur in a precise quantum fractal manner. US dollars are being destroyed through consumer, corporate, and financial default at an unknown but increasing rate with rotational devaluation of equities, and now commodities, serving as a precise quantum fractal mirror of the underlying deterministic macroeconomic process which had boundaries defined by supply and demand, debt load and the ability to service that debt load based on jobs. The macroeconomic system taken by its individual and interconnected parts is complex- but the summation of system’s activity and its ongoing condition in terms of money growth or decline is elegantly simple and is defined in likewise elegantly simple quantum valuation fractal patterns – further defined in the context of valuation saturation curves limiting growth and conversely decay and by areas of nonlinear valuation growth and decay leading to those saturation limits. US real estate and valuable US assets are denominated in a vanishing number of surviving dollars. The dollars previous collapse and current growth against other currencies are following simple readily identifiable Lammert quantum fractal patterns. Private sector and non federal jobs are being lost. Unlike federal government related jobs, the private sector economy is dependent on a bottom line profit margin from ongoing and seasonal buying which in turn is dependent on the collective ongoing wealth of consumers and a loaded pipeline of higher cost durable goods. Even after the equilibratiion of residual dollars relative to other currencies and financial assets, the real private economy will take some time to reestablish former US GDP nominal growth which has largely been based on consumer debt expansion – especially in the last decade. In this setting where there may not be time to allow a slow reestablishment of a functioning credit system, nationalization of much of the US private economy is possible.

  • Posted by Rien Huizer


  • Posted by Alfred

    I agree with everything said in the article I would just caution to not drop the curtain on Trichet and the ECB just yet. The announcement from Trichet to raise interest rates in June was is the main reason behind the decline in commodity prices. After all is it not the main function of every conscious central bank to regulate aggregate demand if this demand causes inflation? Finally commodity prices and most importantly oil are coming down and this is arguably the best thing that has happend to the US economy and global economy in at least 12 month. My guess is that global growth in the second half will rebound and so will commodity prices.

  • Posted by FG

    I think China will find it harder to keep sucking 10% growth from the overstretched consumers in the developed world by keeping its currency undervalued. They’ll have to try something else.

  • Posted by bsetser

    Rebel — my drafting was bad; i meant to say that a rise in the FRBNY custodial accounts doesn’t necessarily reflect new intervention in the fx market. it could also reflect a change in the reserve management of something with a big stock of reserves but that isn’t currently intervening. in this case tho i suspect it reflects the activity of someone who is intervening.

  • Posted by RebelEconomist

    Thanks for the clarification Brad.

    You make a good point Judy, although I had in mind confidentiality about individual holdings – a central bank will often own very large proportions of particular treasury securities.

  • Posted by Twofish

    Most people who mention “quantum” and “fractal” in connection with “finance” don’t really understand quantum mechanics, fractals, or finance. There was some work on using path integral methods for option pricing around 2000, but it turns out not to be terribly useful in day to day practice, even in option pricing.

    The fundamental problem is that its hard to find elegant mathematical solutions in an inelegant world, and if you focus too much on the platonic world of math, you lose sight of the real world.

  • Posted by Twofish

    FG: I think China will find it harder to keep sucking 10% growth from the overstretched consumers in the developed world by keeping its currency undervalued.

    Except that China isn’t. At most China is getting 2-3% growth from exports. The remaining 7-8% comes from internal investment. Also the basic reason that China is growing so fast is that it is recovering from centuries of economic mismanagement, and it’s not hard to find growth opportunities. The US economy by contrast has been run reasonably well for the last two hundred years, and so there aren’t that many places to find new growth.

  • Posted by Troll

    Sorry, Brad, for your disposal of my comments, and your malicious editions of some comments,

    I know that your patience has human limits and I was abusing your church! It was just play! But to follow the money doesn’t mean to follow politics.

    @ Rien Uizer,

    Thank you for your answer to a troll like me, in the previous post.

    I don’t know about D. Chang’s school, nor Brad’s. I’m not an economist and I just follow common sense and results.

    But if you are so sure about “disciplinig power”, could you tell me why the US os A health system is so bad and expensive, compared to european capitalist system health care, which by the way is universal, free for all citizens and governmental (public, in plain english)?

    It has to something to see with Tap Water, systemically talking; not with banks. Just in case!

    Do you think that social security, rail-way system or energy system in France are worse than in US of A? Or are them more expensive?

    Sorry, but you have a lot to learn apart from US of A economics.

    Do you think that there is any democratic nation in the world out of capitalism? in western media?

    Of course there are lots of societies out of capitalism and your models, but you never will talk about them as democratic countries.

    And please, your multilateral models are very old, and try them to work them in US of A, in the first place. Then we’ll decide.

    Tap water, please.

    Why the US of A take his own pharmacy?

    Why don’t you think on the limitations of a very developed state model, buried in debt and miss-investments? With tons of liabilities to the world…? Reserve currency + nukes?

    Technological advantage?

    Go to mass, tomorrow morning, please. Keep on your faith.

    WTO is dead, and US of A corporations will be brought by Chinese, mostly, sooner or later. Or don’t you watch to TV?

    It’s the sign of the times.


  • Posted by Troll


    Why the US of A does´t take his own economic pharmacy?




    Happiness exported trough films?

    It’s like church, preach on thing and do the opposite.

    But, in the end, you export model with hefty bills.

    Nobody asks if they are broken and there is no ruled contest to make them play olympics…

    The little competition from London it’s in our hands, so…

    Go on until it lasts.


  • Posted by euro

    About Georgia and war:;sid=2008/8/9/102157/8633

    Now, let’s be clear about something: Putin’s Russia is not quite a democracy. But then it wasn’t either in 1999-2004, a time when the discourse about Russia’s turn to authoritarianism was rather muted (could it be linked to the fact that its oil sector was, then, almost fully open to foreign investment?). And in the meantime, our own track-record on that topic was rather going in the wrong direction, as painstakingly chronicled on the blogs and elsewhere). Thus my point in pointing out the hypocrisy in the public discourses about Russia is NOT to claim Russia as a model, but to suggest that this public discourse on democracy is hiding something else. And people that accuse me of being too pro-Russian seem to, precisely, miss that point.

  • Posted by bsetser

    troll — one key rule: comments should relate to the post or the conversation …

  • Posted by Troll

    @ Brad,

    Thank you very much your politeness and openness.

    I’m not in the level of commenting your flows analyses from the macro point of view…

    But, don’t you think that this rally on the dollar (Chinese buying of treasuries or whatever) is not gut for rebalancing USA’s deficits, not good for workers, export induestries… Apart of in end of the day RMB appreciation?

    You complain of pegs, but…

    In few words, that strong dollar isn’t good for a country with tons of debt and CA deficits?


  • Posted by Troll

    A comment from a farmer:

    The US farmer just sold the next tractor and he’s just standing in front of his gate and showing that his pockets are full of money. But they are full just because he just sold the next piece of his equipment. And he forgot that he will need more time to do his work without that fine machine. And it will be harder to hold his step with the concurrents. As soon as he’ll spend the money from his pockets, he will sink deeper to the mud, than he was before.

    And the same with US economy. When the lawmakers will give your money to save something can’t be saved, or FED will print new money from nothing. It will make the things seems to be better this week, but the money will be missing elsewhere. Things will go much worser in next months that they were before.

  • Posted by FG

    Twofish: Except that China isn’t.

    To the extent that China policies came back to stopping their currency appreciation to favor exporters, they might find that these policies won’t help quite as much as in the past, because of what is happening in the developed world.

  • Posted by London Banker

    What if Russia agreed to finance the Bush/Bernanke/Paulson reflation of Wall Street and corporate America in return for acquiensence on Georgia? It would be of a piece with Bush foreign policy and the behaviours of both countries over the past five years. There may even be a quid pro quo on US occupation of Iran’s Ahwaz oil fields, with oil and gas prices rising once again after the American elections (as happened in 2004 and 2006).

  • Posted by unokai

    London Banker, instead of dreams of USA involvement in Georgia, be ready for a blowup of BTC pipeline.

  • Posted by Rien Huizer


    Was your article about possible traces of intervention? If so I wonder who would have been intervening. Not the ECB and probably not the US Treasury.

  • Posted by bsetser

    London banker —

    my guess is that casuality runs the other way: a desire to see Russia hold on to its roughly $300 b of dollars rather than dump them constrains us options, and Russia’s financial strength expands its options since it doesn’t have to worry about a financial crisis.

    Rien — I probably shouldn’t have combined what in effect are two posts; one talking about the dollar rally on friday and one talking about the custodial data released on thursday night. I didn’t mean to imply that CBanks bought dollars on Friday, helping the dollar rally then. I suspect that was driven far more by changes in expectations around Europe. I do think that CBank intervention continued through the end of July (and it takes a while to convert $ cash bought in the fx market into dollar securities), with the intervention concentrated in Russia and China. The Saudis/ other oil exporters are also building up dollar balances from oil sales. the buildup in the custodial holdings is consequently evidence of ongoing intervention somewhere, and ongoing CB financing of the US.

    incidentally, does anyone know China’s views on South Ossetia?

  • Posted by Twofish

    bsetser: incidentally, does anyone know China’s views on South Ossetia?

    I think they are trying to figure out what their views are. From a realpolitik point of view, China would favor the Russians, because China gets a lot of things from Russia (fighter jets and oil) and not much stuff from Georgia. On the other hand, China doesn’t want to set a precedent that a strong power can just come in support a secessionist movement, since anything that Russia does in South Ossetia could set a precedent for the US and Taiwan.

    So my guess is that you’ll just get some standard foreign ministry releases about hoping for a peaceful solution while everyone hopes that the problem just goes away.

  • Posted by flow5

    “US os A health system is so bad and expensive, compared to european capitalist system health care”

    There is obviously a gap in quality care between the 2.

    Note that US corporations are burdened with approximately a 10% expense which in turn decreases their world-wide competitiveness.

  • Posted by flow5

    “The fundamental problem is that its hard to find elegant mathematical solutions in an inelegant world, and if you focus too much on the platonic world of math, you lose sight of the real world”

    Absolutely false:

    The transactions concept of money velocity (Vt) has its roots in Irving Fischer’s equation of exchange (PT = MV), where (1) M equals the volume of means-of-payment money; (2) V, the rate of turnover of this money; (3) T, the volume of transactions units. The “econometric” people don’t like the equation because it is impossible to calculate P and T. Presumably therefore the equation lacks validity. Actually the equation is a truism – to sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400 (M) once (V), or $200 twice, etc.

    The real impact of monetary demand on the prices of goods and serves requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt. Income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M). The product of MVi is obviously nominal GDP. So where does that leave us? In an economic sea without a rudder or an anchor. A rise in nominal GDP can be the result of (1) an increased rate of monetary flows (MVt) (which by definition the Keynesians have excluded from their analysis), (2) an increase in real GDP, (3) an increasing number of housewives selling their labor in the marketplace, etc. The income velocity approach obviously provided no tool by which we can dissect and explain the inflation process. ( see: Friedman WSJ 1983, PT=My)

    To the Keynesians, aggregate demand is nominal GDP, the demand for serves (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end.

    Admittedly the data for Vt are flowed. So are nearly all economic statistics, but that does not preclude us from using them. An educated estimate is better than no estimate at all. It is the triumph of good theory over inadequate facts.

    The Fed first calculated deposit turnover in 1919. It reported weekly until 1941. The figure “other banks’’ was used for all calculations until 1996 (prior to this revision Vt included all banks located in 232 SMSA’s excluding N.Y. City). This was the best that could be done to eliminate the influence on prices of purely financial and speculative transactions. Obviously funds used for short selling do not contribute to a rise in prices. The Fed calculates these velocity figures by dividing the aggregate volume of debits of these banks against their demand deposits. Like M3, the series was also discontinued, in Oct. 1996.

    When calculating the flow of funds (MVt) it assumed that the Vt figure reported by the Fed is not only representative all commercial banks in the United States, but that the velocity of currency, etc., is the same as for demand deposits. Is this valid? Nobody knows. But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M. Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal “engine” of inflation – which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds. Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. The (MVt) figure encompasses the total effect of all these money flows.

    Some of the Fed’s technical staff agree this did work, but they have no interest or support for, recreating the series.

  • Posted by gillies

    georgia was thrown to the bear.

    punches were pulled. pipelines were spared. where a pipeline is not defendable against a power with modern technology and almost total local air superiority – what other way is there except a deal ?

    the official story line was not even meant to be believed, at least not by the insiders in the ‘great game.’

    o k maybe i am wrong and kissinger really does worry about results of swimming relays . . .