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Will the US current account deficit fall faster than the IMF forecasts?

by Brad Setser
October 9, 2008

The authors of the IMF’s World Economic Outlook have a difficult job. They have to forecast the trajectory of the global economy — itself not an easy task. Their forecast will be judged and evaluated in real time. But the work according to a schedule set by the need to consult the IMF board and the demands of physical rather than virtual publication. In practice, that means that the forecast never fully reflects the most recent data. “IMF Board” time, “internet” time and “market” time are all very different things.

Sometimes that doesn’t matter. But right now is one of the times when it does. A lot happened this September. And I suspect that much of what has happened isn’t reflected in the IMF’s forecasts.

Specifically, I now expect a larger fall in US output and a larger fall in the US current account deficit — and for that matter, the combined current account deficit of the US and the EU — than the IMF currently forecasts (see the WEO’s data tables).

In the past I have argued that the IMF has had a tendency to forecast problems like the US current account deficit away, and in effect assume that the US current account deficit would tend to shrink even if neither China nor the US adjusted their policies. The IMF has also tended to downplay the role the official sector has played in financing the US.

Now I suspect that there will be more adjustment than the IMF expects.

Specifically, the IMF now forecasts that the 2009 US current account deficit will fall to $485b in 2009 (around 3% of US GDP)– well below its 2006 peak of $790b, and down from an estimated $665b in 2008. The deficit has been running at around $700b, so the IMF is forecasting a fall in the deficit in the second half of the year (see Table A10).

That fall seems reasonable. Indeed, the fall in the United States external deficit could be much bigger:

– the IMF forecast is based on a $100 a barrel average oil price. If oil stays around $90 a barrel, the US deficit would be about $50b smaller (and the surplus of the oil exporters would be reduced by around $150b).

– The credit crunch could cut into investment, reducing demand for imports

– Households seem to have, at least temporarily, stopped spending, pushing savings rates up and cutting into imports.

A rise in the fiscal deficit could help offset the slowdown in consumption and fall in investment — and the pace of US export growth will almost certainly slow as the world slows (the dollar’s recent rebound doesn’t help either).

But all in all, it would seem to me that the US deficit could fall by more than the IMF forecast — in a rather abrupt adjustment triggered by a sudden fall in US household consumption.

The IMF forecasts that the EU’s 2009 deficit to be about $220 billion, roughly the same as the $230b deficit forecast in 2008. That implies the IMF now expects the combined deficit of the US and Europe would fall, and the combined surplus of the emerging world would shrink.

That is important. The US deficit actually peaked in 2006 at just under $800b. It has been falling since. But the $125b improvement in the US current account deficit has been offset, in a global sense, by a $170b deterioration in the EU’s deficit (it went from $60b in 2006 to a forecast $230b in 2008). Yes, Virginia, exchange rates do matter: this deterioration in the EU’s overall balance followed the appreciation of most European currencies

The combined deficit of the US and EU consequently rose over the past two years even as the US deficit fell, allowing — in a broad global sense — Asia’s surplus to rise even as the oil exporters surplus rose. Indeed, in aggregate, Europe (not the US) has been the driver of global demand growth over the last four years. From 2004 to 2008, the US current account deficit rose from $625b to $665b while Europe swung from a $65b surplus to a $230b deficit. That is close to $300b swing in the current account balance of the EU (the swing in the eurozone’s balance is far smaller). From say 2002 to 2005 the US did drive global demand growth, but starting in 2005 the EU picked up and from 2006 through 2008 it carried the baton.

In 2008, the IMF forecasts a combined US and EU external deficit of around $900b — up from $450b in 2002 (see Table A10).

weo-fall-08-1.PNG

What about the other side of the ledger?

Well from 2002 to 2008, the Middle East’s surplus increased from $30b to $440b — and emerging Asia’s surplus increased from $65 billion to an estimated $380 billion. The simultaneous increase in the Gulf’s surplus and China’s surplus explains why the combined deficit of the US and Europe became so large — it was the only way the global economy could balance.

weo-fall-08-2.PNG

The IMF’s data also leaves no doubt that the surplus in both the Gulf and emerging Asia reflects an savings glut not an investment drought. In both regions investment is well above its levels in the 1990s. Savings just increased more (see Table A16).

Looking forward, the IMF doesn’t expect much adjustment in Asia. Its surplus is expected to remain roughly constant in nominal terms — in large part because China’s surplus is expected to remain constant. I agree. Export growth will slow, but so will import growth — and import prices. On balance emerging Asia’s surplus might end up falling by a bit more than the IMF forecasts as the US and Europe slow dramatically.

The Middle East’s surplus is expected to fall from $440b to $365b. That is a meaningful fall — but it still leaves the Middle East’s surplus well above its 2005 and 2006 level of around $250b. Personally, I would expect a bigger fall — in part because I do not current expect oil prices to average around $100 and in part because I expect domestic spending and investment and thus imports have increased by more than the IMF assumes. Forecasts for the Middle East are particularly challenging because the region generally doesn’t release timely balance of payments data!

The IMF’s data tables also are loaded with information about the composition of capital flows to and from the emerging world: Table A13) shows clearly that net capital outflow from the emerging world that corresponds with the emerging world’s estimated $870b current account surplus in 2008 is entirely an official flow. The IMF expects $1270b in outflows from the growth in the emerging world’s reserves and another $160b in “official” outflows (largely the Gulf’s sovereign wealth funds). That implies that the governments of the emerging world are on track to about $1.4 trillion in US, European and Australian assets — along with a few Japanese assets.*

weo-fall-08-3.PNG

The detailed data tables includes estimate of for the oil money that has been channeled through the Gulf sovereign funds (an estimated $150b in 2008) as Asia’s 2008 reserve growth ($750b). In 2009, the IMF expects the Gulf funds to get another $115b — and Asia to add about $550b to its reserves. Net official flows from the emerging world to the US and Europe would remain over a trillion dollars — though they would fall back from the 2007 and 2008 levels.

For once I even think there is a risk that the IMF may have over-estimated official asset growth. The IMF assumed large net private flows would combine with the emerging world’s current account surplus to drive the enormous growth in the emerging world’s reserves and official assets. Net private capital inflows to the emerging world were forecast to top $500b in 2008 — just off the record $630b in inflows in 2007. However, over the last several months — and particularly over the last few weeks — much of the private money that flowed into the emerging world in 2007 and the first part of 2008 started to flow out. That will cut into official asset growth.

As a result, the US almost certainly will rely less on central banks and sovereign funds for financing in 2009 than it did in 2007 or the first half of 2008. That will be true even as the US dramatically scales up Treasury issuance, and the size of the US budget deficit rises. For the first time in a long time, private American households seem to have decided that they need to save a bit of money rather than spend all they take in — and for the first time in a long time private US savers seem to want to hold low yielding US treasury bonds.

And I increasingly suspect that one consequence of United States and Europe’s recent financial crisis will be a smaller deficit in both regions, and a smaller surplus in the emerging world.

NOTE: I added the graphs to this post several hours after I initially put up the text; creating the graphs took a bit of time.

59 Comments

  • Posted by psh

    While I am encouraged by the Fed’s bold new initiative to factor receivables for bookies and whorehouses, I sometimes wonder if anyone has thought about the maturity structure of the treasure trove that we will be acquiring. Or the ultimate ratio of gross flows to net. That could change the picture too.

  • Posted by DJC

    Bernanke’s Academic Wonderland

    http://globaleconomicanalysis.blogspot.com/

    The credit markets are choking on credit, yet Bernanke is attempting to force more credit down everyone’s throats. Logic dictates the solution cannot be the same as the problem.

    Trapped in academic wonderland, such simple logic is far too complex for Bernanke to understand. Sadly, we are all forced to watch Bernanke flop about like a fish out of water attempting to solve a solvency problem with ridiculous liquidity schemes like the TAF, PDCF, TSLF, TARP, and the ABCPMMMFLF.

    The problem is not a failure to lend, the main problem is there simply is no pool of real savings to lend. Furthermore, given rampant overcapacity and rising unemployment, there is no reason to lend even if the funding was available.

    Robbing taxpayers to the tune of $700 billion does not change the equation.

    With that backdrop it’s no wonder Bernanke’s attempts to free up the credit markets are having the effect of pushing on a string. Should the Fed actually stimulate lending, more money will end up in the subprime money toilet as a consequence.

  • Posted by Rien Huizer

    Brad,

    Sound comments and you cannot blame the people at the IMF to be a little behind the times when they publish this sort of material while makets go through a quarter’s worth of movement in one day. Still, extraordinary changes. No more OPEC asset growth, no more US consumer stimulus to the world economy, no more spending real resources in terurn for monopoly money. Recession? Deflation? Or a pretty large inflationary impulse through the nationalized banking systems? My money is on the former.

  • Posted by Michael

    Brad,

    I would agree with your conclusions, and add that the “homecoming” of U.S.-originated money is already adding and will continue to add non-trivially to the improvement in the 2008 & 2009 current account deficits. In addition to the govt. tax holiday for repatriating overseas profits for multinationals, all that stock and bond investment money (or what’s left of it) that went overseas – especially to emerging markets – during the last few years is headed home.

  • Posted by JKH


    Along with CA deficit contraction, the rate of growth in the US gross international balance sheet presumably is slowing down, as per Krugman’s graph the other day – a sort of deleveraging at the first derivative level. The rate of growth in the “hedge fund” effect of the gross balance sheet should therefore be slowing down as well – i.e. in terms of the positive contribution to net investment income. I suppose these two things are sympathetic – it’s a good thing that the deficit is declining rather than increasing if the positive “hedge fund” contribution rate is slowing at the same time.

  • Posted by gillies

    i believe that capitalism is a naturally self correcting system, and instead of fighting this, bernanke should go with it.

    he is like a man turning the wheel away from the skid, when he should be turning into the skid, to have any hope of regaining control.

    but perhaps it is unfair to blame him, when in fact it was the greenspan policy of some years ago that set up the scenario. if greenspan had left interest rates to find their market level – things would have turned bad. but would they by now be any worse ?

  • Posted by Twofish

    DJC: Furthermore, given rampant overcapacity and rising unemployment, there is no reason to lend even if the funding was available.

    Rampant overcapacity and high unemployment is precisely the reason for dropping money from helicopters. It makes no sense to have people and factories lying idle for lack of credit.

    The point about monetary policy being insufficient is well taken, so I suspect that if monetary policy doesn’t work to unseize the credit markets that the next step is to take over insolvent banks and then use them as payment agencies in which the government forces lending in order to prevent unemployment, which is what China did in the 1990′s.

    Speaking of which, I wouldn’t be too surprised if within a decade the big three auto makers end up being state owned enterprsies.

  • Posted by FG

    Twofish: It makes no sense to have people and factories lying idle for lack of credit.

    You are talking like all that is needed is more credit and debt.

    At least part of the US economy in the past years relied on ever growing debt to exists. Once this part goes away, we see what we are seeing now.

    And this is a good thing. It is not a waste. Overall people will be happier once this part is removed and we can build again on a healthy foundation.

  • Posted by DJC

    Behind the Panic: Financial Warfare and the Future of Global Bank Power

    by F. William Engdahl
    http://www.globalresearch.ca/index.php?context=va&aid=10495

    US Goldman Sachs ex CEO Henry Paulson, as Treasury Secretary, is not stupid or incompetent. Quite the oppositie. There is serious ground to believe that he is actually moving according to a well-thought-out long-term strategy. Events as they are now unfolding in the EU tend to confirm that.

    That process of using panics to centralize their private power created an extremely powerful, concentration of financial and economic power in a few private hands, the same hands which created the influential US foreign policy think-tank, the New York Council on Foreign Relations in 1919 to guide the ascent of the American Century, as Time founder Henry Luce called it in a pivotal 1941 essay.

    Paulson, and his friends at Citigroup and JP Morgan Chase, had a strategy it is becoming clear, as did the Godfather of Asset Backed Securitization and deregulated banking, former Fed Chairman Alan Greenspan, as I have detailed in my earlier series here, Financial Tsunami, Parts I-V.

    Knowing that at a certain juncture the pyramid of trillions of dollars of dubious sub-prime and other high risk home mortgage-based securities would come falling down, they apparently determined to spread the so-called ‘toxic waste’ ABS securities as globally as possible, in order to seduce the big global banks of the world.

    The panic is bringing the world one step closer to a global money market controlled by Paulson’s cronies—US-style Crony Capitalism. Crony Capitalism is certainly appropriate here. Paulson’s predecessor at both Goldman Sachs and at Treasury, Robert Rubin, liked to accuse the Asian bankers of Thailand, Indonesia and other lands hit with the speculative attacks of US-financed hedge funds in 1997 of ‘crony capitalism,’ leaving the impression the crisis was home grown in Asia and not the result of a deliberate executed attack by US-financed financial institutions to eliminate the Asia Tiger model among other goals, and turn Asia into the funder of US debt.

  • Posted by Guest

    Will Macro-Man change his job faster than Gordon Brown forecasts it?

    Let’s them work how to get out of their mess…

    Nobody is free… or …

  • Posted by bsetser

    if anyone has ideas for how to get out of this mess, i am all ears ….

    i have some ideas — but what I thought was too radical to be seriously considered two weeks ago (public equity injections to recap the banks) is now the expectation.

  • Posted by moldbug

    Recapitalization is a half-measure. It does not resolve the underlying maturity-crisis uncertainty.

    What banks need recapitalization, and how much do they need? As asset prices tumble, the answers to these questions change every second. Worse, you cannot rely on the banks themselves to do this math, because applying to the program is a signal of weakness.

    The problem is that people say “nationalization” when they mean “recapitalization.” Perhaps some other word needs to be used.

    Talk of USG guaranteeing interbank lending is better. But basically, when you (a) buy shares and (b) guarantee liabilities, you start to sound like you’re making a purchase.

    The basic problem with interbank lending guarantees is that the guarantee needs to be temporary, but must become permanent. Withdraw the guarantee and everyone rushes for the exits again. And is the problem really the fact that banks can’t borrow money? They already have an alphabet soup of facilities to borrow under, some of which appear to accept used gum wrappers as collateral.

    Assuming liabilities – bringing them onto USG’s balance sheet, in some way or other – is a completely different matter. And it is not some crazy plan for Weimar hyperinflation. Really, all we’re talking about here is moving dollars from M2 to M0. (Unfortunately, there is no monetary aggregate notation that describes the shadow banking system – or has room for the bizarre flora of synthetic instruments it has underwritten. But you get the picture.)

    Under some circumstances, yes, this could be inflationary. But once the bleeding is stopped there is plenty of time to sterilize. A dollar in M0 is not necessarily ten dollars in M2. And right now, the market needs a tourniquet. The limb is basically a writeoff, anyway – the financial system that emerges from this crisis need not, should not, and very likely will not resemble the one that went in.

    In the long term, the US needs to figure out how many dollars are outstanding and fix that number as a constant – probably backing it with its mold reserves. But this does not need to be done tomorrow.

    Nationalizing the banks might need to be done tomorrow, and closing the markets while a plan for this is designed is an obvious first step. I don’t think there is any law of physics which requires the NYSE to open on Friday. And if Secretary Paulson’s last press conference is any indication of his neurological status, there is certainly a law of biology which requires him to get a nap sooner or later.

  • Posted by adiemuso

    A global coordinated writeoff and cash pool by all the banks in the world.

  • Posted by glory

    “If money isn’t loosened up, this sucker could go down.” —President Bush, Sept 25, 2008

  • Posted by glory

    depressionomics http://www.ft.com/cms/s/1/d36567c0-95ca-11dd-9f42-000077b07658.html – “look at it this way. The IMF estimates that US and European banks need to shrink their balance sheets by $2,000bn a year over the next five years. That is a terrifying contraction in the supply of global credit. If governments do not pick up the slack, the world risks falling into what is called the ‘paradox of thrift’. Here, everyone cuts back spending simultaneously. Companies retrench, jobs are cut and consumption falls further. A deflationary spiral begins. This was the plight of Asean countries after their 1997 crisis. They only wriggled free thanks to growing exports – a solution that cannot work for the whole world.”

  • Posted by glory

    the US CAD has been a tremendous source of credit creation around the world,* but if this ‘pump’ — http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2005/IO+May-June+2005.htm — has run its course, with the CAD finally contracting then, unless it (global credit creation, CAD expansion) is taken up elsewhere (anywhere! who has the wherewithal to do so?),** a global contraction in economic activity appears inevitable.*** else http://www.businessdayonline.com/analysis/backpage/16794.html – “From central bank to central planning?”

  • Posted by glory


    * _something_ greenspan seems to have noticed http://www.federalreserve.gov/boarddocs/speeches/2005/20050204/default.htm – “Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit.” interesting indeed! :P
    ** altho it’s conceivable that the fed’s b/s expansion and treasury borrowing could take it on (altho the 10-yr yld *rising* in recent days suggest they might be beginning to run into limits)

  • Posted by glory

    *** per http://edge.org/3rd_culture/dysong08.1/dysong08.1_index.html

    The roots of the current financial meltdown can be found in John von Neumann’s “Model of General Economic Equilibrium,” first developed in 1932. Von Neumann elucidated the behavior of an expanding autocatalytic economy where “goods are produced not only from ‘natural factors of production,’ but… from each other…” and proved the coexistence of equilibrium and expansion via the saddle-point topology of convex sets. Some of his assumptions—such as that “the natural factors of production, including labour, can be expanded in unlimited quantities” and that “all income in excess of necessities of life will be reinvested”—appeared unrealistic to others at the time, less so now that Moore’s Law, and the zero-cost replication of information, is driving the economy of today. Other assumptions, such as an invariant financial clock cycle, are conservative under the conditions now in play.

    Von Neumann, who made seminal contributions to digital computing, left a number of distinct monuments to his abbreviated career: among them his “Theory of Games and Economic Behavior” (with Oskar Morgenstern) and his “Theory of Self-Reproducing Automata” (with Arthur Burks). Synthesis between these two regimes is now advancing so quickly that no unified theory of the economics of self-reproducing systems has been able to keep up. Periodic instability should come as no surprise. We may be on the surface of a balloon. Or in the saddle of a dynamic equilibrium—we hope.

    The unlimited replication of information is generally a public good (however strongly music publishers, software developers, and other pockets of resistance disagree). The problem starts, as the current crisis demonstrates, when unregulated replication is applied to money itself. Highly complex computer-generated financial instruments (known as derivatives) are being produced, not from natural factors of production or other goods, but purely from other financial instruments. When the Exchequer splits the tally stick in two, the King keeps the gold and silver, and you keep one half of the stick. Derivatives are the equivalent of splitting off (and selling) further copies of the same stick—or the “clipping” and debasing of coinage that led Isaac Newton to spend the later part of his life reforming the financial system as Master of the Mint.

    The result is a game of musical chairs that follows von Neumann’s model of an expanding economic equilibrium—until the music stops, or we bring in Isaac Newton, whichever comes first.

  • Posted by aim

    Brad,
    The banks are afraid to lend with good reason. Maybe for a short period of time, the government can provide insurance on loans the banks are making to business and other banks. If libor can be brought down, the stock market may be able to bottom and buy some time until the MBS reverse auctions.

  • Posted by black swan

    “if anyone has ideas for how to get out of this mess, i am all ears ….”

    NO PAIN, NO GAIN

    Replace Paulson with David Walker

    Allow investment banks to fail, and fortify strong existing banks

    Bring all troops back from foreign wars and cut the devense budget by 50%

    Make all bank level 3 assets and Federal Reserve’s collateral transparent

    Price controls on Big Pharma

    Repeal the Gramm-Leach-Bliley Act

    Pass a new Glass-Steagall Act

    Start full-scale investigations into the financial dealings of Hank Paulson, Jamie Dimon, Jimmy Cayne and Timothy Geithner

    Backstop the municipal bond crisis before their are failed public pensions and massive public layoffs

    Pass and enforce serious conflict of interest laws

  • Posted by Judy Yeo

    hmm, skimmed your russian post – well, old news but the russian market tanked yesterday – suspended for 2 days

    Saw an article asking for mathematical rationality in the guardian yesterday – unless they are saying that the math models used in risk assessment were all flawed, if not, there was gross misinterpretation – it was the flawed assessment and failed redistribution of risk that has partially led to today’s situation- – looking for a return to mathematical and logical sanity requires confidence based on dependable models- in other words cutting out the human factor.

  • Posted by Twofish

    FG: You are talking like all that is needed is more credit and debt.

    Pretty much, but credit and debt have their limits and it looks like we may have reached them.

    FG: And this is a good thing. It is not a waste. Overall people will be happier once this part is removed and we can build again on a healthy foundation.

    I don’t think people will be happier. The problem with “let’s let the world fall apart so that we can build a better system” is that the world falls apart and no better system results.

  • Posted by Twofish

    I sometimes wish the conspiracy theorists were right and this is
    all part of some big power grab, because if there was this secret
    plot to rule the world, you can at least be confident that the
    people running that plot wouldn’t destroy themselves.

    The truth is quite a bit more frightening and that is that people
    are just people, trying to figure out what to do with limited and
    incomplete information, and often being wrong about what to do.

  • Posted by Twofish

    The thing that really is starting to worry me is that we’ll start to get into the “Argentine death spiral.” When things go bad, the natural reaction is to “shoot the bankers and businessmen.” It’s a natural reaction, but that usually makes things worse, causing people to want to shoot more bankers and businessmen, and then things spiral downhill until you’ve completely wrecked the economy far worse than it was originally.

  • Posted by Twofish

    moldbug: Recapitalization is a half-measure. It does not resolve the underlying maturity-crisis uncertainty.

    Resolving the underlying maturity-crisis uncertainty would involve going back to doing things the way that things were done before 2003, and making sure that demand deposits are backed by assets which can be rapidly converted to cash, and whose value is not dependent on economic conditions. Mortgages to prime borrowers in which the owner has a large fraction of equity and absorbs price rises and falls, are in the the category of assets that you can back demand deposits with, since those mortgages have almost no little risk (prime borrowers), little market risk (owner absorbs house price changes), and interest rate risk can be dealt with by requiring banks to not pay interest on demand deposits.

  • Posted by moldbug

    2fish, no asset is safe in a bank run / maturity crisis.

    For example, even if we assume that prime mortgages have no default risk, when everyone starts converting them to cash, their price falls. Since we’ve postulated an absence of default risk, this fall must represent an increase in the long-term interest rate. But it’s a fall anyway, and it makes the banks insolvent.

    Eg: look up M0 and MZM. You will find that MZM is about 10 times M0. Ie, the banks owe ten times as many dollars, now, as exist in the world. It does not matter what assets they own. They could own all the other goods on the planet. But as long as they cannot print dollars and do not have a big brother who can, it is physically impossible for them to make all their depositors whole. This means that the rational depositor withdraws ASAP, and the run starts.

    I agree 100% on the Argentine death spiral, however.

  • Posted by Twofish

    moldbug: 2fish, no asset is safe in a bank run / maturity crisis.

    Depends.

    moldbug:For example, even if we assume that prime mortgages have no default risk, when everyone starts converting them to cash, their price falls. Since we’ve postulated an absence of default risk, this fall must represent an increase in the long-term interest rate. But it’s a fall anyway, and it makes the banks insolvent.

    At which point the Federal Reserve opens up the discount window and then loans money using the mortgages as collateral. This is precisely why the Federal Reserve exists. If you have a situation were there is no default or market risk, the Fed doesn’t lose money on this.

    If you hate central banks, then none of this is going to work, so if you want to have a system that doesn’t have a central bank, then you have to deal with the mismatch problem in another way.

    The trouble is that if you have questionable assets then this doesn’t work.

    moldbug: But as long as they cannot print dollars and do not have a big brother who can, it is physically impossible for them to make all their depositors whole. This means that the rational depositor withdraws ASAP, and the run starts.

    But they do have a big brother that can print money. Where this system breaks is if the assets of the bank are actually bad, in which case you have a solvency problem rather than a liquidity problem. One other problem comes in if the value of the assets are uncertain. If you have standard residential mortgages, you can calculate their value easily and then you know how much to pay for them.

    If you have some weird asset, you have no idea what they are worth, and finding the “market value” is not useful when there is no market.

  • Posted by JKH


    Moldbug:

    “But as long as they cannot print dollars and do not have a big brother who can, it is physically impossible for them to make all their depositors whole.”

    I don’t see this. There’s certainly no monetary or bookkeeping constraint here.

    Suppose the US banking system experiences a run of $ 10 trillion.

    This is a run from M2 to M0.

    The fact that M0 is currently only 10 per cent of M2 is not a constraint.

    E.g. the central bank cuts a cheque to the government for $ 10 trillion and records an asset entry on its books called “Present value of US human capital in support of extraordinary funding for the 2008 credit crisis”. This may seem like nonsense, but the central bank can monetize anything. This is the true meaning of the helicopter speech.

    The central bank funds that “investment” by issuing $ 10 trillion in bank notes and “selling” these notes to the commercial banks.

    The commercial banks pay for the notes by drawing down their reserve deposits with the central bank into a $ 10 trillion deficit position.

    The banks distribute the $ 10 trillion in bank notes to their customers and eliminate their deposit liabilities to them.

    The government distributes its $ 10 trillion cheque proceeds as deposits with the banks in proportion to their deposit losses. This funds their assets and makes their reserve accounts whole.

    In theory, if this offset to the run were orderly, there is no reason for bank asset prices to be affected. But a suspension of mark to market accounting would be natural at this point.

    You end up with a banking system funded by government deposits and a populace holding central bank notes. This looks suspiciously like your MT paradigm.

    Linking the expansion of bank notes to inflation at this point is ridiculous, of course, since the entire operation is meant to offset the risk of hyper-deflation.

    Solvency and recapitalization aspects become secondary issues. E.g. the government could charge interest on its deposits as a function of the return on private capital, or fully nationalize, or partly nationalize/recapitalize, or whatever. There’s unlimited flexibility in dealing with commercial bank balance sheets going forward from there. And the holders of $ 10 trillion in bank notes may get tired of earning 0 % interest at some point.

  • Posted by moldbug

    JKH, 2fish:

    “as long as they cannot print dollars and do not have a big brother who can” was a syntactically tortured counterfactual. In reality they do have a big brother who can, as you point out, so I don’t disagree.

    There is another problem, however…

  • Posted by moldbug

    2fish: “Where this system breaks is if the assets of the bank are actually bad, in which case you have a solvency problem rather than a liquidity problem.”

    This little sentence gets to the root of the whole present crisis, which is that there is no market mechanism which can distinguish between insolvency and illiquidity. You are trying to solve an equation of two unknowns for two unknowns.

    Moreover, the two are connected in a feedback loop, due to the role of housing prices in collateralizing these loans. So there is simply no “natural” equilibrium for these prices to convverge on. It is all a matter of administrative policy, or should be.

    Free markets didn’t get us into this crisis, and free markets aren’t going to get us out. The lazy fairies can wait. Serious proactive energy is essential.

  • Posted by Twofish

    moldbug: This little sentence gets to the root of the whole present crisis, which is that there is no market mechanism which can distinguish between insolvency and illiquidity.

    It’s actually a deeper problem. Valuations depend on the ability to see into the future, and there are limits to which you can do that.

    Also if you are not a bank or if you are a bank with government insurance, then you can be insolvent without being illiquid.

    moldbug: Moreover, the two are connected in a feedback loop, due to the role of housing prices in collateralizing these loans. So there is simply no “natural” equilibrium for these prices to convverge on. It is all a matter of administrative policy, or should be.

    Yup. That’s the basic problem, and one of the reasons that we got into this mess was when housing values started to play a major role in the valuation of assets. If you have a conforming prime mortgage to a borrower with good credit, the value of the loan is very insenstive to the price of the house.

  • Posted by satish

    2fish- Govt wants to bail out banks who lost their money by placing bad debts. If they were prudent in first place this mess would have not happened. Why bailout bankers. Give credit directly to common people who lost their homes,cars and their livelyhood. Atleast common person can benefit first from inflation and money from people will automatically recapitalize banks when they can repay their debts with money from fed.
    Current situation tells only if you are big you will be saved and your debt written off. As a common person you cannot have debt written off because fed does not bail out common people

  • Posted by JKH

    Moldbug,

    The article suggests lease rates have increased due to heightened central bank awareness of counterparty risk. You suggest this dynamic, left unchecked, would cause gold prices to skyrocket. But such a dynamic, left unchecked, would also seem to contradict the vested interest of central banks in alleviating the problem of systemic counterparty risk more generally in the prevailing credit crisis. In other words, it’s in their interests from a policy perspective to modulate the pace at which lease rates increase by continuing to provide the lease market with some degree of liquidity?

  • Posted by DJC

    Fortunately Asian banks are very little directly exposed to the US financial problems. The state-owned Bank of China, the only Chinese bank with a license to operate in the United States, was exposed to $9.7 billion in AA-rated subprime mortgages. It has been entirely written off. Most Asian banks especially state-owned institutions have an insular domestic focus and minimal international exposure.

    Badly burned by Wall Street’s manipulated 1997-98 Asia Crisis, Asian banks have largely escaped damage to their balance sheets. When the subprime mortgage fiasco exploded earlier this year, all of the financial pundits on CNBC were crowing about how the Chinese banks were loaded with US subprime garbage. Well, just wishing it were so, doesn’t make it true.

  • Posted by Cedric Regula

    Been thinking about the TARP 2 version we have as an alternative to buying bad mortgage paper at face value. The capital infusion could be better, if…if…if…if, done properly.

    I just reminded myself of all the foreclosures, bad car loans, credit cards, etc…going into a recession where these things generally get worse…and if I caught myself seriously thinking of getting into banking right now, I would go visit a shrink instead, in spite of what Buffet thinks. But they passed the law already, so my shrink will just say live with it.

    But we probably do have a mix of insolvency and liquidity problem. i.e. there are some consumers that haven’t used up all their credit yet, some first time home buyers that could qualify for home loans (but I think the mix of young doctor just starting out does not match up well with where the foreclosures are located).

    And there are probably viable businesses that could use a credit line.

    So trying to alleviate solvency by capital injection may allow liquidity to go where it does some good. Combined with deposit guarantees, we may get money out of T-Bills and back into bank CDs for use by the private sector at the fractional banking 8:1 ratio over the gov cash infusion amount.

    However dropping helicopter tax dollars into zombie banks makes no sense. So I’d like to see the treasury gang up with the FDIC and do terror raids on zombies and support the healthy banks after given them the bad liabilities from closed banks. Then take taxpayer equity which may be worth something in 5 years or so.

    Also everyone gets too confused if they have to figure out who’s a zombie and who isn’t all on their own.

    This may make Libertarians and Don Luskin scream bloody murder, but let ‘em.

    Also, the problem just got much worse with stock markets plunging around the world. The specter of triggering corporate bank loan covenants is very real now. Companies that have a revolving line of credit may now be cut off because their stock price has fallen below contractual covenant levels with their bank.

  • Posted by Twofish

    DJC: Fortunately Asian banks are very little directly exposed to the US financial problems.

    Yes they are. Most of them have exposures to treasuries and agency bonds in the form of dollar denominated debt. So they are going to be very heavily exposed if the currency shifts.

    DJC: Most Asian banks especially state-owned institutions have an insular domestic focus and minimal international exposure.

    Not true. The Chinese banks have a lot of international exposure. They are well capitalized enough so that they aren’t going to get hammered, but they do have international exposure. Also, domestic exposure to real estate and export industries is something that also has to be looked at.

  • Posted by Twofish

    satish: Govt wants to bail out banks who lost their money by placing bad debts. If they were prudent in first place this mess would have not happened. Why bailout bankers.

    Bailing out banks is not the same thing as bailing out bankers. When you go to a bank and a nice person gives you a car or home loan, they aren’t giving you any of their own money. They are giving you the money of that other person at the teller window that is depositing a check.

    Banking is difficult business precisely because the people who are making the decisions as to what to do with the money, aren’t playing with their own money.

    You want to punish bank *managers*. You want to protect bank *creditors*.

    satish: Give credit directly to common people who lost their homes,cars and their livelyhood.

    First priority is to make sure that no matter what happens, people don’t lose their checking and savings accounts. If you don’t have a system of checking and savings accounts, then you don’t have a way of giving out credit.

    satish: Current situation tells only if you are big you will be saved and your debt written off.

    Banks aren’t having their debts written off. Banks live in a mirror image world in which loans are assets, and deposits are liabilities. Banks owe money to people that hold checking and savings accounts, and if the bank goes poof, those accounts also go poof.

    satish: As a common person you cannot have debt written off because fed does not bail out common people.

    The fed is trying to bail out everyone with a checking, savings, or money market account and so far has been sucessful at this. A lot of banks are broke. FDIC if it has to pay out everything is broke. Without Fed money, checking and savings accounts go poof, and without checking and savings accounts the financial system crumbles.

  • Posted by Twofish

    Personally, I think we’ve past the danger period.

    The Dow might go down another 1000/2000/3000 points. Who knows? Who knows when the credit markets are going to get unstuck. We are probably going to have a nasty, ugly recession.

    However it looks like that the basic tools of finance checking/savings/CD/money market funds are secure, and being able to put money into a checking account and know that you can take it out again, is the difference between a recession and a depression.

  • Posted by DJC

    Twofish,

    If you haven’t noticed, the US Dollar has been going up versus the Euro and British pound in the past couple months. And US Treasury yields have plunged which translates into higher bond prices. The Chinese don’t own the subprime garbage peddled by snake-oil salesmen especially Goldman Sachs Paulson.

    The Bank of China has probably 98% of assets in mainland China and Hong Kong. If you exclude Hong Kong which is really part of China, the overseas assets representing a few dozen or so Bank of China branches in New York, Singapore and San Francisco don’t amount to a hill of beans.

    Just recall all those CNBC reporters and economists who said China would collapse after the olympics. The US media told the fable many times that US has the most advanced financial system. In the past few days, $2 trillion of 401K retirement funds have evaporated. My next door neighbor who works for Hess Oil Corp told me that Lehman screwed their firm out of $35 million just days before declaring bankruptcy. At least the Chinese can sleep safely at night without their money being stolen by thieves.

  • Posted by Pallj

    Looking for mathematical rationality in free market economics will not be successful. Unless you manage to define the heard instinct in mathematical terms (and so what, if you do?), since it is the heard instinct which drove the markets up and the same instinct polarized is driving the markets down.

    If the free markets were of a rational nature you would expect stock prices to be in some kind of harmony with dividends, and not just revolve around how optimistic investors are about future investors’ optimism. Or pessimistic about future pessimism, as is the case of late. Where is there room for mathematical rationale in that? Sure, you can create formulas and compute how to panic quicker than the rest, but that doesn’t alter the fact that you have panicked and found yourself in a stampede.

    Supposing the world is moving towards some kind of state capitalism, which is happening without any political dialogue, the challenge becomes how to reverse that new order back to what we had before. That will surely involve a lot of political debate around the world, to put it mildly.

    The most sensible act of the Bush administration was to ban short selling, which is in essence an “un-investment”, and as such a purpose defeating act. It should be a priority to ban the rest of the financial vehicles that have been instrumental in generating the chaos of late, and I am sure it will be easy to analyze which are the bad apples of that lot.

    Sleight of hand in the financial world needs to be well defined, and punishable.

  • Posted by Pallj

    sorry about the misspelling of herd. embarrassing…

  • Posted by satish

    2fish-
    Investment bank’s clientale does not have small investors or common citizens. ordinary US citizen’s has practically no savings. It’s the rich and ultra rich have all the savings.
    Ordinary citizens cannot save due to ultra low intersets of greenspan era.
    Debt of rich people will get wiped off and will have new good credit but ordinary citizens will have to repay old debt with new debt.

  • Posted by aim

    bsetser Says:

    if anyone has ideas for how to get out of this mess, i am all ears ….

    i have some ideas — but what I thought was too radical to be seriously considered two weeks ago (public equity injections to recap the banks) is now the expectation.

    As I said earlier:

    The banks are afraid to lend with good reason. Maybe for a short period of time, the government can provide insurance on loans the banks are making to business and other banks. If libor can be brought down, the stock market may be able to bottom and buy some time until the MBS reverse auctions.

    Note that the IMF has funds to back stop bank to bank lending at least.

  • Posted by DJC

    October 08, 2008, it was reported: The very next week AIG received 85 billion dollar taxpayer bailout from total collapse, AIG executives spent more than US$440,000 of company money on a week-long getaway at an exclusive California beach resort for a complete SPA treatments, banquets, etc. included US$23,000 at the hotel spa and another US$1,400 at the salon. The daily rate for one room is minimum $425 per night up to $1,200 per night.

    Hank Paulson then rewards AIG corporation with another $35 billion in taxpayer money for prudent management of US government funds. LOL.

  • Posted by moldbug

    JKH,

    “You suggest this dynamic, left unchecked, would cause gold prices to skyrocket. But such a dynamic, left unchecked, would also seem to contradict the vested interest of central banks in alleviating the problem of systemic counterparty risk more generally in the prevailing credit crisis. In other words, it’s in their interests from a policy perspective to modulate the pace at which lease rates increase by continuing to provide the lease market with some degree of liquidity?”

    It is certainly in their *collective* interests to do so. However, if the run psychology (which is still very early) develops, it is not in the *individual* interest of any individual CB – because no reserve manager wants to be caught with defaulting leases. And if everyone gets out, some leases will default.

    Moreover, the country that should be the 800-pound gorilla in the room, the US, does not AFAIK (or as far as anyone knows) have the authority to lease its gold, although it may have sticks it can use to persuade non-US CBs to do so. I suspect it has done so in the past.

    But this international cohesion seems to be evaporating a little. The end of mutual trust and collective action between CBs is really what would be the end of the Bretton Woods era. It is also the logical last domino to fall. Of course, that doesn’t mean it will.

  • Posted by moldbug

    Paul de Grauwe gets it…

  • Posted by Cedric Regula

    Pallj:

    Actually I think fear is rational behavior. Humans are wired for it because it is a survival instinct. So when we see something big and scary, we get scared.

    The one useful thing that short selling does is accelerate the demise of unsuccessful companies. Problem in the current scenario it is too weak of a solution and works too slow. And there is considerable collateral damage. i.e. if you don’t know what you’re doing, short the financial SPDR.

    But the financial sector was 20% of the S&P 500 by pre-crash market cap and clearly needs downsizing.

    Problem is if we need to preserve any of it, it would be checking and savings accounts. Without those we have stomped civilization back to the 1700′s.

    I do not want to start doing 2 goats for a pig, 5 chickens for a goat, and economic growth is having a boy goat and a girl goat in the back yard.

    So thats why we need deposit insurance, backed by the treasury or fed printing presses if neccesary. That attacks the fear factor. Next we need the FDIC to decide winners and losers quickly and downsize the banking system in line with economic need.

    Then if we survive this, a very serious look needs to be taken at what kind of financial instruments are allowed, and also rationalize mortgage lending standards. Be nice if we re-criminalized white collar crime too.

    Perhaps we need something like the FDA for financial products. Do it like drug apps. Make Wall Street present their products for approval and make their case why we need them. If we can’t understand them, the answer is NO!

  • Posted by thor

    greg mankiw have a good idea. public money should capitalize what private money have chosen.

  • Posted by Pallj

    “Perhaps we need something like the FDA for financial products. Do it like drug apps. Make Wall Street present their products for approval and make their case why we need them. If we can’t understand them, the answer is NO!”

    I like that! That would make a lot of practical sense.

    It’s not that fear itself is irrational, but what is scarier, the stampede itself or the cause of the stampede?

    Any measure that can decrease the volatility of a market sounds like a good idea to me.

  • Posted by Pallj

    Yes, mbug, Paul de Grauwe puts it very neatly indeed.

    The Icelandic banks that failed all had enviable equity and were turning a profit as they failed. One is hoping that under state ownership again they’ll eventually get the wheels back in motion here, but as the profitable business they were these banks are history.

  • Posted by DJC

    China’s Leaders ignore US financial fiasco, focus on domestic rural problems

    http://online.wsj.com/article/SB122357413898519675.html#printMode

    BEIJING — China’s leaders began an annual policy-setting meeting Thursday, turning their attention from the global financial crisis to the economic issues facing the nation’s 730 million farmers.

    The decision to focus the high-level Communist Party conclave on rural matters shows how China’s relative insulation from the credit crunch is allowing it to continue working on a crucial long-term issue. It also shows the gravity of the situation in the countryside. China’s reforms began there 30 years ago, but rural incomes have been growing only slowly and grain production has reached a plateau.

    President Hu Jintao has signaled that this week’s meeting will take up the question of rural property rights.

  • Posted by glory

    re: state capitalism (run by ex-goldman alums and PIMCO ;)

    We need a new banking system… The Great Depression had bank failures, we have bank zombies.”

    From central bank to central planning? …despite all this, we still have not had enough central planning in finance. For, even as the central banking authority administered the price of liquidity, the price of risk was left to the tender mercies of the market. And it is the price of risk that is the source of our current distress… The Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price.”

  • Posted by gillies

    have any of the contributors who were recently so anxious for the chinese to get out of the doomed dollar, and into the euro, commodities, etc. – sent flowers, chocolates, or an apology of some kind ?

    - and when is mr paulson’s next lecture tour of beijing ?

    - and to all world leaders this weekend who think that there is no easy way out – look, the crash IS the easy way out.

    - and as the fastest way out of a crash is straight through it . . . . why persist in trying reducing interest rates to a level at which people are once again prepared to borrow ? why not raise interest rates to a level at which people are once again prepared to lend ?

    - buffet is right when he says that we have experienced – or are experiencing – an economic pearl harbour. but history never repeats itself, and i suspect that the difference is that this time around WE are the japanese.

  • Posted by glory

    from the WSJ: Japan’s finance minister said his country is prepared to help bail out nations running out of funds amid the worsening global financial crisis.

    [flush with nearly $1 trillion in foreign exchange reserves] “We are ready to provide our funds to the IMF,” Mr. Nakagawa said.

    Such a move would send a lifeline to countries like Iceland, where the government’s efforts to bail out the country’s three biggest banks has pushed the small nation to the edge of bankruptcy.

  • Posted by glory

    http://economistsview.typepad.com/economistsview/2008/10/the-bernson-pla.html
    The country of Bubblia has a problem… Alan Bernson, a loyal government servant in charge of the Federal Car Reserve, has an idea. We’ll call it the “Bernson Plan”. Currently, because of all the lemons in the car market…

  • Posted by Akin

    The very process of financial innovation changes the probability of default.
    http://takingnote.tcf.org/2008/10/moral-hazards-o.html

  • Posted by Michael

    Brad,

    I think you’ve got the solutions you requested, in a two-step process, right here among the comments on your blog:

    1. ” – and as the fastest way out of a crash is straight through it . . . . why persist in trying reducing interest rates to a level at which people are once again prepared to borrow ? why not raise interest rates to a level at which people are once again prepared to lend?” – Gilllies

    (This is the solution to the “Death of a Thousand Cuts” deleveraging chaos we are now experiencing)

    2. “Then if we survive this, a very serious look needs to be taken at what kind of financial instruments are allowed, and also rationalize mortgage lending standards. Be nice if we re-criminalized white collar crime too. Perhaps we need something like the FDA for financial products. Do it like drug apps. Make Wall Street present their products for approval and make their case why we need them. If we can’t understand them, the answer is NO!” – Cedric Regula

    (This is the post-crisis way to not have to go through the same thing again in twenty years)

  • Posted by glory

    http://www.washingtonpost.com/wp-dyn/content/article/2008/10/01/AR2008100101149.html – “Since the 1990s, risk management on Wall Street has been dominated by a model called ‘value at risk’ (VaR)… Lurking behind the models, however, was a colossal conceptual error: the belief that risk is randomly distributed and that each event has no bearing on the next event in a sequence… But what if markets are not like coin tosses? What if risk is not shaped like a bell curve? What if new events are profoundly affected by what went before? Financial systems overall have emergent properties that are not conspicuous in their individual components and that traditional risk management does not account for. When it comes to the markets, the aggregate risk is far greater than the sum of the individual risks… As long as Wall Street and regulators keep using the wrong paradigm, there’s no hope they will appreciate just how bad things can become. And the new paradigm of risk must be understood if we are to avoid lurching from one bank failure to the next.”

  • Posted by Howard Richman

    Brad,

    This is what the start of a global depression looks like. With American households unable to borrow, savings currently exceeds investment in the world economy, even though investment is high. First stock markets crash, then investment crashes, then prices go down, then factories lie idle.

    Only the Asian trade-surplus countries, especially China, can pull the world out of this right now. The Asian governments could do so if they suddenly switched to all-out fiscal, monetary, and trade policies designed to stimulate consumption and imports and reduce their countries’ savings.

    That won’t happen. Instead, China will buy even more dollars and euros in hopes of lowering their currencies versus the dollar and euro stealing more U.S. and European market share. This will cause U.S. companies to go bankrupt, but won’t help keep their factories active because the markets for their goods will be shrinking too fast.

    Ironically, the current Chinese leadership is signing its own death warrants when they continue to pursue their export-oriented-growth policy even after that policy is no longer possible (due to debt-laden consumers in the importing countries). When factories go idle in China, a hardline-Communist ruler will take over and force the current leadership to undergo re-education sessions where they have to confess their capitalist tendencies.

    The United States still has a solution which avoids all of this. Warren Buffett’s Import certificates plan ( http://money.cnn.com/magazines/fortune/fortune_archive/2003/11/10/352872/index.htm ). There is no surplus of savings in the United States. If we adopt the Buffett plan to balance trade, our businesses stay profitable no matter what happens in the rest of the world.

    Howard Richman
    http://www.tradeandtaxes.blogspot.com

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