Brad Setser

Brad Setser: Follow the Money

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Quaint

by Brad Setser
August 13, 2008

The Economist – in the course of its analysis of the Fed’s response to the credit crisis — noted that only a few years ago the Fed got rid of its Agency holdings because it didn’t want its asset purchases to distort the allocation of credit in the US economy.

“Politicians have asked the Fed to favour certain industries or keep interest rates low almost from its birth. In 1921 the Fed rejected requests from Congress to buy long-term agricultural debt. In the 1940s and again in the 1960s, under pressure from the Treasury, it bought bonds to hold down long-term interest rates. In the 1970s, at the behest of Congress, it bought the debt of federal agencies such as Fannie Mae and Freddie Mac.

A 2002 staff study pointed out the risks of favouring particular assets or borrowers: it could result in too much investment in preferred sectors and too little in others, drag the Fed into arguments about fiscal policy and compromise its monetary policy. In recent decades the Fed largely extracted itself from anything resembling credit allocation. The last of its Fannie bonds matured in 2003.”

Obviously, the Fed has shed its inhibitions here over the past year — though helping the banks avoid forced sales of their existing assets into an illiquid market arguably has less impact on the allocation of future credit than buying securities other than Treasuries when times are good. still, there are concerns that the Fed is now shaping the allocation of credit in the US economy. The Economist writes:

“The central bank is lending to private companies on an unprecedented scale and is thus making decisions it long sought to avoid about the allocation of credit. It is also acquiring new powers of oversight. Politicians could chafe at the Fed’s power: why, they might ask, should unelected officials choose who benefits from taxpayers’ money? And they might press the central bank to pursue political ends—such as propping up favoured borrowers—that interfere with monetary policy ….

That brings up an interesting question: If Americans are uncomfortable having the Fed shape the allocation of credit in the US economy, shouldn’t they be equally uncomfortable when foreign central banks — notable China’s central bank — shape the allocation of credit in the US economy through their asset purchases?

The PBoC now has a larger dollar balance sheet (on the asset size) than the Fed. It holds around a trillion dollars of Treasuries and Agencies (over $950b can be identified using the TIC data, and the TIC data understates China’s holdings … ). The Fed has around $900 billion in assets — $940 billion, to be precise.

Moreover, the PBoC’s dollar balance sheet is growing far faster than the Fed’s dollar balance sheet. The Fed has responded to the credit crisis by changing the composition of the assets it holds, not by increasing its holdings. The PBoC by contrast is adding to its foreign assets at an extraordinary rate.

Back when the Fed was getting out of the Agency market in 2003, China was getting into the Agency market. In a really big way. China has bought close $100 billion of Agency debt a year now for several years – and likely bought far more over the past year, though accurate data isn’t yet available. As the US stood down, China stood up — so to speak.

There is an argument, popular at the Fed, that claims central bank intervention in the market has little impact. If a central bank buys Treasuries and pulls rates below their “true” rate, private investors will sell Treasuries until they return to their natural equilibrium. Consequently, central bank demand doesn’t have a big impact on Treasury yields. If central banks buy a ton of Agencies, lowering the yield for mortgage backed securities, private investors will shift their funds toward sectors that central banks are ignoring and push yields back up. There won’t necessarily be more funds available to finance housing.

If this argument holds for the actions of foreign central banks, it presumably also holds for the actions of the Fed — and there wasn’t much need to worry that the Fed’s purchase of assets other than Treasuries might influence the cost of credit in the US. And well, if the Fed’s small purchases could favor one sector over another, wouldn’t far larger purchases from foreign central banks have a similar effect?

That possibility though raises a host of difficult issues that the United States has preferred to ignore. Among other things, it implies that China’s government already plays a significant role in determining the allocation of credit inside the US economy, not just the allocation of credit inside China’s economy.

34 Comments

  • Posted by Shrek

    No one cares Brad until something goes really wrong.

    As far as I am concerned China is absolutely cluess and in true communist fashion is trying to micro manage everything it can. I cant stress enough how important it is to have PRIVATE investors shaping investment decisions. Not only do we not have that right now, China seems hell bent on distorting things for as long as possible

  • Posted by Rien Huizer

    A very interesting piece related to the matter of moving prices in large, liquid markets. Under normal circumstances, moving prices in a very large market would require buying or selling a significant percentage (how much depends, but it would have to be so large and sustained that other investors would be discouraged to arbitrage the move away. Such an operation would of course be made much easier if the “mover” had credibility (i.e. for instance, was widely believed to have significant resources in reserve if the first move did not have the desired effect), and/or if the market was already leaning towards the move. The opposite, an actor without credibility, working against market entiment, would require very high amounts to preempt speculation that the effect would be traded away quickly.

    In the old FX markets of the late 1980s and early 1990s, large “power traders” could have a significant effect, and astute fx dealers would cherish clients with power trading strategies, given the largely unregulated nature of FX trading, such a dealer could ride the coat-tails of the market disturber on the way up and on the way down, with little risk. However, after a while, when the Euro arrangements became more and more firm and governments started this fiscal policy convergence, it became harder and harder for power traders to make real money.

    Implications of what you observe:

    (1) Fed should be worried more about credibility, especially given its recent mercenary employment in the credit crisis (as the Economist in the same issue refers to Grenspan’s biography, that is not a job for a Central Bank) and if that credibility weakens, lack of ammunition (do not see at this point how) would become critical and should be prevented at all cost.
    (2) China cannot play the role of a power trader. The Fed would pick this up immediately through its market monitoring and probably escalate the matter to diplomatic levels, be it discretely. It would be considered hostile behaviour. But what China can do and is doing, is creating a steady, predictible flow, based on a myth: that it will continue to have a voracious appetite for paper even if the supply slows down (thus intervening in the part of the yield curve where the Fed does not have a mandate, complementary behavior, but not necessarily (!) coordinated), that myth based on other myths such as the employment imperative and the clout of the cadres in the coastal provinces all promoting inefficient exports. No one knows if those myths are true and it is impossible to validate even partial hypotheses based on them. But the difference between credibility and being favored by a myth is merely one of semantics, and both rquire the absence of contrary evidence.
    (3) Of course, if China’s portfolios keep growing, even minor adjustments may begin to have “power trading proportions”. If/when that happens, SAFE will probably have to adopt some form of explicit signaling behaviour (as the Fed does now but of course in an official capacity and that behaviour may require US gvt cooperation) unless they want to become a writer of free options to the rest of the market, somewhat similar to convergence trades in the european bond markets prior in the run-up to the Euro and not a viable long term policy.

    It would still be a difficult situation, specially for the primary dealers, I think. What if the Treasury issued special tranches for foreign central banks to be traded only via the Fed (no dealer intervention) and convertible into ordinary treasuries etc at a nominal fee, but subject to Treasury approval)? They could still be priced of the market, as long as things were fully transparent. Not very likely. the US benefits in the short term from Chinese mythology, no explicit coordination needed. But that may not always be the case.

    Nevertheless, a very interesting subject. Yet another symptom of PRC policy constraints coming up.

  • Posted by Qingdao

    Brad pinpoints what the Chinese might call an economic equivalent of an acupuncture point: “…it implies that China’s government already plays a significant role in determining the allocation of credit inside the US economy, not just the allocation of credit inside China’s economy.” This insight raises “a host of difficult issues.” The first issue might be to look at how the Chinese government allocates credit inside China. (Short answer: poorly). The recent iteration of this ongoing debate in Beijing now pits those who favor growth against those who would contain inflation. Michael Pettis argues convincingly that the growth faction unfortunately has the upper hand.
    Far more interesting for Americans is how China effects credit allocation inside the U.S. The Fed manipulates the federal funds rate in order to influence short-term interest rates which, with a significant lag, influence long term interest rates. The resultant change in aggregate demand will hopefully decrease unused capacity leading to price pressure in the desired direction. But what if long-term interest rates were determined not by the Fed, but by PBofC buying an unprecedented quantity of long-term bonds? We now know the answer: inflation, not in CPI, but in asset (housing) prices and subsequent sub-prime mortgage crisis. Few saw this coming, least of all the Chinese.
    If you believe (as I do) that the Chinese economy is about to experience a downturn, maybe it’s time to speculate on how that may effect “credit allocation” within the U.S. My guess is : not much; slightly higher long term interest rates, stronger dollar, fewer exports, lower oil prices. The editorial pages will then we turned over to the foreign policy types describing rising tensions in Asia as economies slow

  • Posted by Matt

    Ok guys, terribly interesting but the question is Why? Why would China purchase a low-performing asset with dim prospects in such volumes? Rien’s point 2 above is important.

    However, next step, and this might be hard for the economists, is that the decisions are not based on rational position or return. This is structured, strategic leverage. To do what with?! Well, take yr pick.

    I didn’t spend four years in Beijing just showing up to pick decent noodle bars for lunch.

    MD

  • Posted by Sam

    Regarding Rien’s points above, particularly the “power trader” view. A spot Euro dealer I know once said China is the EUR/USD market. The difference however is that Soros, Druckenmiller, Salomon were profit maximizers and actually good traders

  • Posted by Dave Chiang

    If the U.S. is concerned about foreigners owning too much Treasury debt, I have a radical solution, reduce federal deficit spending by tightening your belt, stop selling Treasury bonds to foreign Central banks. It’s really that simple. The China PBoC and Russian Central Bank isn’t forcing the US Treasury to sell limitless quantities of debt securities to finance deficits.

    Perhaps it is time for the Washington Consensus to stop digging a hole in the ground to China. The United States can no longer afford to be global supercop around the world. The idiotic Iraq occupation is destroying the US Army and wasting hundreds of billions of dollars for absolutely nothing in return.

    The same Washington Consensus Elites who can’t manage a babysitting day care think they are entitled to dictate political and economic policies of the Chinese government. Without the constant meddling of Washington bureaucrats, the rest of the world can actually manage their internal affairs quite well. Please leave the rest of the world alone.

  • Posted by shrek

    Stop selling them to FCBs? Why dont they stop buying them. No private investors want 4 percent yields in a bad currency. Its only the retarded clown governments from around the world especially the chinese. Does China plan on maniupulating its way to prosperity?

  • Posted by Dave Chiang

    Shrek,

    In order for the China PBoC to buy US Treasury bonds, the US government has to sell them. If something isn’t sold, then no one can buy.

    In Saudi Arabia, the rape victim woman is always blamed for the crime.

    In Washington DC, the China PBoC victim is blamed for US government deficit spending.

  • Posted by Rien Huizer

    DC,

    Your regular references to the Washington Consensus, do you mean the points Williamson once suggested and later substantially withdrew? Or it it something sinister that you associate with the US-China conumdrum? China can afford to be economically irrational as long as its people put up with it or until other countries force it to stop because they do not like the externatilties and they have the power to stop it. I have no idea when that will happen or even if it ever will, but it can probably go ith it longer than the US will, because the US has a political system that, sooner or later, gets rid of incompetents.
    Well, many might say, perhaps China is not all that irrational, by adopting these policies it can gain a unique advantage in the long term. It is very simple: the Washington consensus (a la Williamson) is an excellent set of institutional features for countries at a certain level of development, not a quick fix for very backward countries with deep seated political pathologies. Suggesting that kind of institutional reform to a country where neither the leaders nor the rest of the population are socialized towards behaving responsibly from a communautarian point of view and also having a reasonanbly efficient economy with market supporting institutions, does not make a lot of sense. The fundamental debates on this blog are about whether China is deliberately ignoring certain efficiency opportunities for political reasons (i.e. politicians’ selfishness or a paternalistic form of altruism (?)), not ignoring eficiency as much as many think, and not as much victim of predatory (I would consider entrenchment as a form of predation) or paternalistic policies, or perhaps pursuing a unique brand of developmentalism (following the catching up approach advocated (or not rejected) by people like Chang Ha-Jun or Robert Wade). I like to be involved in that debate because I think it is interesting and the blog medium is ideal for this, who knows, maybe it even contributes to the welfare of waterbuffalos in Guizhou. I am not so sure that finding out what makes China tick is very important to you though! But your tenacity is admirable.

  • Posted by Dave Chiang

    Rein Huizer,

    I think they have really lost their marbles in Washington DC. We already have two hot wars in Iraq and Afghanistan. The Neo-con Military-Industrial complex is sending Naval Battlegroups to Iran to start a third. Now Bush is sending US military personnel to Georgia to confront the Russians for a fourth conflict.

    From Afghanistan, Iraq, Iran, to Russia. The US hasn’t even won in Afghanistan, but we are moving on to bigger and bigger targets to attack. Totally Insane !

    Kuwait on alert for war in Persian Gulf
    Tue, 12 Aug 2008 07:58:03 GMT
    http://www.globalresearch.ca/index.php?context=va&aid=9815

    Kuwait has activated its Emergency War Plan after an armada of US naval battle groups headed for the Persian Gulf, Middle East Times reports.

    The report comes after DEBKAfiles claimed on Monday that the USS Theodore Roosevelt, the USS Ronald Reagan, and the USS Iwo Jima are sailing toward the Persian Gulf to reinforce the US strike forces in the region.

    The US naval force is accompanied by a British Royal Navy carrier battle group and a French nuclear hunter-killer submarine.

    The deployment is believed to be the largest naval task force assembled by the United States and its allies in the region since the Persian Gulf war in 1991.

    The move comes nearly a week after Operation Brimstone, which saw more than a dozen warships from US, British and French naval forces conduct war games in the Atlantic Ocean in preparation for a possible confrontation with Iran.

  • Posted by Rien Huizer

    Sam,

    Re yr #6. China may have a very large “end user” demand for FX spot transactions, because of trade flows. To what extent the SAFE traders have a mandate to manipulate the market using very large abrupt bursts (that is what I call powertrading) I have no idea, but I doubt it, athough they may have huge natural flows and the FX regime should lead to large scale centralization. To what extent there is a notion of some “neutral” position and what kind of deviation from neutrality is considered permissible (position limits?) and how things are delegated and monitored would be extremely interesting. Something for a reader/contributor who works at SAFE?

    However, FX powertrader or not, it is more or less the same situation as with the longer end of the US yield curve, if everyone believes that someone will regularly do something that others cannot prevent and affects them, people start to adjust their behavior.

  • Posted by shrek

    I have the curve on my screen all the time and it NEVER moves. In fact I dont know anyone who even trades bonds anymore because they never breakout.

    The highest inflation in 17 yrs was today! and that still couldnt get vol going. There is one reason for this. everytime yields breakout some stupid government (china) goes bid. I swear the US should just mail all its bad debt to china because theyre too stupid to care about resource allocation

  • Posted by RebelEconomist

    Brad,

    As you might expect given my previous comments about the Fed’s own contribution to the “conundrum”, I am interested to read that the Fed would refrain from investing in the debt of certain issuers to avoid preferring them, while they apparently did not worry about the effect of buying relatively long term debt.

  • Posted by bsetser

    We need to get macroman into the “power-trading” discussion. my sense is that the PBoC is more the buyer/ seller who sets limits on market moves than the instigator most of the time, but I would defer to folks with true trading experience.

    re: China’s large end user demand — that is true, but that isn’t what shows up with SAFE’s activity. moreover, to the extent that chinese firms still invoice in dollars, it is the European buyer of Chinese goods who will be in the EUR / USD market selling EUR for USD to pay Chinese suppliers. Some of the dollar inflow then pays for China’s imports — but a lot ends up in the hands of SAFE/ the CIC. They flows here — in China is on track to add $800b to its foreign assets this yeer — are simply huge.

    p.s. I saw a Wapo article indicating that Asian SWFs have big positions in commodities (via index funds). One SWF has positions that are known to the US regulators, the others go thru the i-banks. I heard a rumor last fall that SAFE was dabbling in commodities as well. anyone know more?

  • Posted by Dave Chiang

    Shrek,

    It’s so easy to blame the Chinese for everything. In order to to ease the burden off Brad Setser’s shoulders, why don’t I just accept responsibility on behalf of the Chinese people that the Chinese are responsible for everything that goes wrong in the US Economy. Never once has Brad criticized current or past Federal Reserve monetary policy, the present 2% interest rate policy of “cheap money” by the Federal Reserve is reckless and irresponsible.

    In fact, the Federal Reserve has rigged the entire US interest rate market mechanism, not the Chinese government. From Shadowstats.com , the Federal Reserve is engaged in a frenzy of money printing with broad M-3 money supply exploding at a hyperinflationary 15% annual rate to bailout politically connected Wall Street investment banks. Inflation is a stealth transfer tax from the middle class/poor to the banks that have access to Federal Reserve money creation first.

    Annual U.S. Money Supply Growth Statistics
    http://www.shadowstats.com/alternate_data

  • Posted by bsetser

    DC — I criticized the fed’s policy in 05/06, when i thought the Fed should have used int. rates to restrain aggregate demand growth/ push against the housing boom. I linked to a Ted Truman paper that made this argument as well. I also criticized US fiscal policy, especially in 04/05. I would note tho that the fed cannot be held accountable for the fact that long-rates stayed below short rates, to its surprise. it can be held accountable for not raising rates more when the long-rate didn’t move as expected.

    I have criticized the Fed’s recent policy b/c I agree with it. And the data strongly indicates that the Fed isn’t printing money — base money (and the fed’s balance sheet) isn’t expanding. I have by contrast crticized those who have imported us monetary easing (and dollar weakness) despite much stronger domestic circumstances.

    now back on topic please — i.e. should the US care if other governments are shaping the internal allocation of credit in the US? And if so, how should it respond?

    One conceivable response would be to raise short-term rates to attract more private financing — tho this likely would leave the deeply truobled us financial system even more troubled and require an explicit tax payer bailout. Maybe that is a better option — who knows.

  • Posted by Dave Chiang

    Yes, short-term rates should be raised that would decrease consumption, increase savings, and reduce the US trade deficit with the world. That’s just what the Doctor would order. At the very least, the Fed discount rate should match the current rate of inflation. Certainly that would that leave Wall Street banks further in the hole that they dug themselves into, but the US government has a legal obligation to the broader needs of society. “Rent seeking activities” achieved by the US financial services industry will thereby become much diminished. For the rest of the US economy, this denouement cannot come quickly enough.

  • Posted by don

    It seems to me that we needn’t worry about the distributional effects of China’s policies within the U.S. credit market too much, because the market is well developed and substitution elasticities are high – the marginal investors will reallocate to offest distortions introduced by lop-sided Chinese investments.
    However, we should worry about the effect of China’s policies on the overall level of this debt, because different currencies are not such close substitutes. Hence lop-sided Chinese investments that favor the dollar will not be so readily offset by arbitrage among debt in different currencies.

  • Posted by anon

    There’s a difference between concern about risk pricing and concern about risk.

    And there’s a difference between domestic taxpayer concerns about a domestic central bank versus concerns about a foreign central bank.

    Whether or not the Fed’s activity has changed risk pricing, it has changed risk facing the US taxpayer – first due to the actual change in the Fed’s balance sheet; second due to the contingent liabilities associated with various forms of intervention e.g. Fannie and Freddie. Arguably it has changed risk pricing, but mostly as a result of the latter rather than the former.

    You can’t really say the same thing about the effect of foreign central bank activity on the US taxpayer, can you? (With the exception of the curve “conundrum”, which has nothing to do with credit risk, and which is arguably an exaggerated claim.)

  • Posted by bsetser

    fyi — there were some technical problems that made commenting difficult this afternoon. to anyone who lost a comment — my apologies. I know how it feels; i lost a few comments myself. the problem is now resolved.

  • Posted by bsetser

    anon– interesting points. my concern is about the pricing of risk/ distribution of credit, so the limits on the risk born by the (US) taxpayer don’t obviate it. they in effect assume that don is wrong, and market doesn’t perfectly offset the distortions among various asset classes introduced by lopsided Chinese demand (I fully agree that currencies aren’t close substitutes, so the biggest impact would be on level of debt/ pricing of US debt v European debt). and here it is worth noting that the concerns that led to the fed to stop buying agencies were about the allocation of credit and pricing of credit — not about taxpayer risk.

  • Posted by anon

    I’m rather stunned by this argument “inside the Fed”. I thought that a change in the price of Treasuries was part and parcel of the global savings glut thesis. Does Bernanke himself believe that Treasury pricing is not affected by China’s activity (and did Greenspan?), or is this a “rogue” Fed staff argument? In either case, it’s a rather fundamental challenge to the conventional wisdom. Treasuries are ground 0 for risk pricing. Is there a wider academic school that believes in this theory? (I think it’s not unreasonable, at least directionally, myself).

  • Posted by Twofish

    China does have an effect on the overall amount of credit available to the US economy, but I really don’t see it having an effect on the distribution of credit. The bond market is efficient enough so that if there is excess demand for one type of bond instrument, everything will rearrange itself so that that demand gets spread over the entire bond market.

    If the PBC suddenly decides that it is going to loan money only to mortgages on blue houses, supply and demand is going to cause the interest rate of blue houses to be slightly below the interest rate of red houses. The millisecond that happens, you have a gazillion bond traders, buying blue house loans and selling red house loans, and the interest rates will move to equilibrium long before it has any economic impact.

    Certainly the PBC activities have an impact on the total amount of credit, but the bond markets are incredibly efficient, and everything redistributes itself very, very quickly.

    Another image is sucking water out of a swimming pool. How much water you suck out makes a huge difference. What side of the pool you suck the water from, doesn’t.

  • Posted by Twofish

    Shrek: As far as I am concerned China is absolutely clueless and in true communist fashion is trying to micro manage everything it can.

    It’s actually not. This afternoon, I had a falafel sandwich. In order to get that falafel sandwich thousands of things had to work just right, and the reason why everything worked was that I gave someone some green bits of paper that caused a lot of things to work just right.

    Trying to organize a centrally planned economy so that people would end up with falafel sandwich doesn’t work. The Chinese economy is basically a market economy. It’s a market economy with heavy state intervention and state ownership, but its a market economy.

    Shrek: I cant stress enough how important it is to have PRIVATE investors shaping investment decisions.

    I can’t stress enough how irrelevant it is to have investors be PRIVATE. If you have private investors, but they are incentivized to loot the companies they control or to work with other private individuals to engage in rent seeking behavior or to increase returns by increasing risk with the expectation that when things blow up they will be long gone, you get a disaster.

    By contrast if you have state employees whose incentives are to promote long term growth in their holdings, things work well. Look at Calpers.

    One thing that I found interesting was that a lot of the economists that were offering advice in the 1990′s had very little real contact with markets and business. They’d never tried to work as a bond trader, or run a company, or done very much outside of academia. (For example, it turns out until the late-1980′s that shareholders had basically zero voice in running most large American companies, and being a shareholder in a large industrial company gives you as much power over the Board of Directors as being a voter in China gives you over the Politburo.)

    So you end up with these cartoon picture versions of the US economy, that don’t work too well for the US economy, but become totally disasters if you try to mold a developing economy after that.

  • Posted by bsetser

    anon — this argument is a variant on “sterilized intervention” has no impact on the market, b/c if the us government say trades us bonds for european bonds, private investors will keep prices from deviating from their “fundamental value” by doing the opposite. This is why dooley, garber and folkerts-landau for example argue that it doesn’t matter whether emerging market central banks buy euros or dollars — only that they buy foreign assets. Greenspan certainly subscribed to this — he consistently has argued against the claim that central bank demand explained low rates.

    Bernanke i am less sure off — at times his work has suggested a fairly limited impact on the treasury market, but the logic of the savings glut generating us deficits requires the “glut” to drive down us rates. my sense is that he tends to think that the modalities of how this all happens aren’t important — i.e. central bank purchases are just a detail. what matters is the rise in savings v investment in the emerging world — and resulting demand for us financial assets. in this view, it doesn’t matter so much whether the vector bringing the emerging world’s savings to the us is private investors buying equities or central banks buying bonds.

  • Posted by Michael

    I agree with Shrek that the Chinese central bankers have an extremely conservative (yes, even stupid and maybe harmful) approach to investing their savings. They focus strictly on near-term domestic economic priorities and couldn’t care less how the U.S. is affected – with the exception of the importation of Chinese exports. However, I also believe that the American central bankers have an extremely conservative (yes, even stupid and maybe harmful) approach to investing their…savings? Give me a break. The Fed has to print money in order to invest it – the U.S. has no savings at any level. And of course, they focus strictly on near-term domestic economic priorities and couldn’t care less how China is affected – with the exception of the importation of American exports.

  • Posted by anon

    bsetser – very interesting; thx.

  • Posted by Rien Huizer

    Brad, yr # 15 /powertrader: looks like the opinions here vary from stifling intervention (shrek’s stationary curve) to irrelevance (twofish). That also looks like correlation without a theory (shrek) and theory without evidence (twofish)! Anyway, I guess we ll agree that China shows no signs of deliberaltely manipulating the market opportunistically for short term gains. I do believe though that Shrek’s comments indicate that China has developed a degree of credibility in the long end of the curve (easiest explanation of Shrek’s Voorwerp). It is a subject that deserves much attention, especially if preferences between the US gvt and the Chinese would start to conflict (which they seem not to be doing at the moment). As to markets being so large and liquid that intervention cannot be makes no effective (Twofish), I totally disagree with that.. But it is possible that the intervener in last resort, i.e. the US gvt via its agencies, is constrained in such a way that it cannot intervene effectively without having to sacrifice other goals. Governments just printing money and central banks combatting inflation singlemindedly do not belong in grown up society. Well, if the US cannot always get what it wants in its own capital markets, why would China be able to intervene with any effect. I think it could but only in theoretically and bstracting from political consequences: if China crated a nuisance there would be some extra-market response. The Fed has excellent micro-structure knowledge within its system. It cannot prevent Chin from buying paper but it can do a lot to counter whatever it might consider abuse. The point is, of course, what would China and the US do if they had a very deep disagreement (say China would have added three trillion to its stash, some bright spark at SAFE would talk his bosses into yield enhancement through active management (trying to be a little Soros) and start dumping treasuries whilst being indiscreet about it in the pub where the economic scribblers are). That might cause long term interest rates to go up, the rest of the market to panic (the initial effect of a credible actor moving the market abruptly) and produce a rsult that the US gvt might not like (probably). What would hppen is anyone’s guess, but probably there would be consultation. Washington does not care about the external value of the USD that much, but it does care about someone moving interest rates outside the Fed-Treasury consensus. And then the US would ground the PoBC for a month or so. Some people in Washington and Beijing must have been brainstorming about this from time to time, so the bright spark would be more likely a Leeson than a Soros (after the fact of course) and things would go back to normal. Meanwhile Bright Spark’s friends from the pub could have made a little fortune.

    As to end-user demand from spot FX transactions: not privy to any pertinent information but I would also expect that to be not “overwhelmingly” large. It may be more concentrated and in a time zone where markets are a little thinner. But institutional demand, interbank trading and very large japanese firms may also be quite important in Asian time. I guess it depends where you are and what kind of FX work you do, whether SAFE is important.

  • Posted by aim

    bester Says: ‘private investors will keep prices from deviating from their “fundamental value” by doing the opposite’

    This seems like a very reasonable assumption, but can’t private investor’s influence in a market be overwhelmed by many central banks? This issue goes beyond Chinese purchases.

  • Posted by Simon

    I can add!!!Cripes I was going to make a great post!

  • Posted by Simon

    I agree with DC. The capital miss-allocation problem originates on Wall Street no where else. The Chinese are paragons of responsibility compared with the facilitators of the spoilt ivy league Wall Street brats that have engaged in activities that threaten to seriously damage the financial stability of the entire planet.

  • Posted by RebelEconomist

    “should the US care if other governments are shaping the internal allocation of credit in the US? And if so, how should it respond?”

    Yes, the US should care and should do something about it. If the Fed believe that their investment has an influence on credit pricing, as I pointed out long ago if they also believed that mortgage rates were being held down by Chinese purchases of longer term debt, they should have shortened the duration of the SOMA account. They had enough treasuries in the SOMA to counteract much of the conundrum. For more detail, see:
    http://reservedplace.blogspot.com/2008/01/us-economic-policy-shot-in-foot-1-soma.html

  • Posted by bsetser

    Rien — interesting points. I have been thinking a lot about these kinds of scenarios. I am a bit less convinced that you are that the fed has a tight grip on the microstructure of all us markets (they completely missed the SIVs buying ABS — they really thought there was a lot of global risk dispersion) as you are. but i also don’t know all the things the markets group at FRBNY tracks.

  • Posted by Rien Huizer

    Brad re yr # 35. I just meant that their tracking of trading patterns (market microstructure) is pretty sophisticated and should show up irregularities like people trying to manipulate markets supervised by them, like markets made by the primary dealers. That should show up “powertraders” in trasuries. As Twofish mentioned, manipulating that market is highly unlikely (connections with other markets, near-fungibility), but I would not rule out that a situation of “credibility” could arise, given a lot of ammunition and a plausible myth.

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