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The end of Bretton Woods 2?

by Brad Setser
October 21, 2008

In late 2004, Nouriel Roubini and I wrote that “the tensions created [by the Bretton Woods 2 system] are large, large enough to crack the system in the next three to four years.” In a 2005 Wall Street Journal online debate with Michael Dooley I tried to hedge a bit, and gave the system six years.

“we [Roubini and Setser] never said the system would collapse at the end of 2005. A collapse in 2006, maybe. A collapse before 2008, likely; before 2010, almost certainly.

I used to worry that these dire warnings would prove to be wrong – and that Michael Dooley and Peter Garber would remind me of them at a time and place of their choosing. Now I am starting to worry that Nouriel and I may end up being partially right.

The available trade data for q3 does not show a fall in either the US deficit or China’s surplus. But I increasingly suspect that the combination of falling oil prices and falling demand for imported goods will produce significant fall in the US trade and current account deficit in the fourth quarter, with a corresponding fall in the emerging world’s combined surplus. The Bretton Woods 2 system – where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports – will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much.

And rather than ending with a whimper, Bretton Woods 2 may end with a bang.

In some sense Bretton Woods 2 has been on life support for a while now. China’s recent export growth has depended far more on Europe than on the US. US demand for non-oil imports peaked in 2006. One irony of the past year is that the US was borrowing far more from China that it was buying from China. Campaign rhetoric that the US was paying for Saudi oil with funds borrowed from China isn’t far off – though it leaves out the fact that the US also borrows from Saudi Arabia to pay for Venezuelan, Mexican and Nigerian oil.

If Bretton Woods 2 ends in 2009 – if US demand for imports falls sharply in the last part of 2008 and early 2009, bringing the US trade deficit down – it won’t have ended in the way Nouriel and I outlined back in late 2004 and early 2005. We postulated that foreign demand for US debt would dry up – pushing up US Treasury rates and delivering a nasty shock to a housing-centric economy. As Brad DeLong notes, it didn’t quite play out that way. The US and European banking system collapsed before the balance of financial terror collapsed. Dr. DeLong writes:

All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the ‘Balance of Financial Terror’ between Asia and America to collapse and produce chaos. We are not having that financial crisis. Instead we are having a very different financial crisis. Catastrophic failures of risk management throughout the entire banking sector caused a relatively minor collapse in housing prices to freeze up global finance to a degree that has not been seen since the Great Depression.

The end result of this crisis though could be rather similar: a sharp contraction in credit, a fall in US economic activity, a fall in US imports and a fall in the amount of foreign financing the US needs.* The US government is (possibly) trying to offset the fall in private demand by borrowing more and spending more — but as of now there is realistic risk that the fall in private activity will trump the fiscal stimulus.

Consequently, this still strikes me a crisis of the Bretton Woods 2 system. In retrospect, Bretton Woods 2 depended on two things: ongoing flows from the emerging world’s governments to the US Treasury and Agency market, and the ongoing ability of the US financial system (broadly defined to include the dollar-based “shadow” financial system operating in London and other offshore centers) to transform these flows into loans to ever-more indebted US households. US investors** effectively sold their holdings of Treasuries and Agencies to the world’s central banks, and then redeployed their funds into private-label mortgage-backed securities. Between the end of 2003 and q2 2007 (three and a half years), the stock of mortgages held by private issuers of asset-backed securities rose from about $1 trillion to around $3 trillion. That demand meant that credit was available to any household that wanted it – even those without much ability to pay if the housing market ever turned.

Or, to put it more succinctly, Bretton Woods 2, as it evolved, hinged both on the willingness of foreign central banks to take the currency risk associated with lending to the US at low rates in dollars despite the United States large current account deficit AND the willingness of private financial intermediaries to take the credit risk associated with lending at low rates to highly-indebted US households.

The second leg of the chain collapsed before the first. And it collapse looks set to deliver a nasty shock to everyone – including the countries that supply the US with vendor financing.

In some sense, the vendor finance analogy never really worked. The “vendor” financers didn’t actually lend directly to the US households that were buying their goods. The big emerging market central banks were willing to take on currency risk associated with lending to the US but not the credit risk associated with lending to US households.

That didn’t matter so long as US financial institutions were willing to take the credit risk.

But now US financial institutions are neither willing nor able to take on the risk of lending even more to US households. For a while the US government was able to ramp up its lending to households (notably through the Agencies) and in the process effectively take over the function previously performed by the private financial system (over the last four quarters, the flow of funds data indicates that the Agencies provided around $800 billion of net credit to US households). But now the US government is struggling to keep the financial system from collapsing. It doesn’t seem like it will able to avoid a sharp fall in the overall availability of credit.

In retrospect, the fact that (reported) bank profits didn’t fall as the Fed raised rates should have been a clue that risks were building. An inverted yield curve isn’t good for institutions that borrow short and lend long – but it initially didn’t seem to have an impact on financial sector profitability. It is now clear how the financial sector kept profits up: it took on more risk, as it shifted from borrowing short to buy safe long-term assets (Treasuries and Agencies) to borrowing short to buy risky long-term assets. Leverage in the system also increased (and for some broker dealers that seems to be an understatement), as more and more financial institutions believed that the US had entered into an era of little macroeconomic or financial volatility. The net result seems to have been a truly explosive concentration of risk in the hands of a core set of financial intermediaries in the US and Europe. Securitization – it seems – actually didn’t disperse risk into the hands of institutions able to handle it.

Many have highlighted the role that loose US monetary policy played in supporting the housing boom. And there is no doubt much truth in this story: pushing rates down to help “clean” up the bursting of the .com bubble and holding them down for several years certainly helped induce the rise in home prices and the housing boom. At the same time, this story leaves out what to me is a crucial part of the story: the housing boom didn’t end when the Fed reversed course and raised long-term rates. The really risky loans were made in late 2005, 2006 and early 2007 – after policy rates had increased. Private institutions kept on lending – in part because they decided that it was safe, in a world of low assumed macroeconomic volatility – to take on more leverage and more credit risk to keep profits up.

Foreign central banks that kept on lending to the US despite large ongoing deficits – and poor returns, after taking into account the currency risk – on their dollars contributed too. If they had scaled back their financing more rapidly, the US would have been forced to adjust sooner – reducing the risk of the kind of severe crisis we are now in.

I hope that the process of adjustment now underway isn’t as sharp as I fear. The US economy gradually can shift from producing MBS for sale to US investors flush with cash from the sale of safe securities to China and Saudi Arabia to producing goods and services for export – but it cannot shift from churning out complex debt securities to producing goods and services overnight. Indeed, in a slowing US and global economy, improvements in the US deficit will likely come from faster falls in US imports than in US exports – not from ongoing growth in US exports.

But right now it looks like there is a real risk that the adjustment won’t be gradual. And it certainly looks like the flow of Chinese (and Gulf) savings to US households over the past few years has produced one of the largest misallocations of global capital in recent history.

US taxpayers are going to be hit with a large tab for the credit risk taken on by undercapitalized financial intermediaries. Chinese taxpayers may get hit with a similar tab for the losses their central bank incurred by overpaying for US and European assets as part of its policy of holding its exchange rate down. The TARP is around 5% of US GDP. There are plausible estimates that China’s currency losses will prove to be of comparable magnitude. Charles Dumas puts the cost at above 5% of GDP:

“Charles Dumas of Lombard Street Research estimates that China makes 1-2 per cent on its (largely) dollar reserves. It then loses up to 10 per cent on the exchange rate and suffers a Chinese inflation rate of 6 per cent for a total real return in renminbi of about minus 15 per cent. That is a loss of $270bn a year, or a stunning 7-8 per cent of gross domestic product.”

I have estimated that the annual cost of adding $600b (15% of China’s GDP) of unneeded reserves to China’s stockpile is roughly 5% of China’s GDP — though the exact loss depends on the size of the RMB’s eventual appreciation. Others have calculated large losses to Chinese households on the basis of the very low rates China has maintained on domestic deposits to support the RMB.

The US taxpayer are currently getting hit with the tab for much of the credit risk that supported the big increase in US household consumption – as Martin Wolf quipped, what looked to be private lending turned out to be public spending. And China’s taxpayers will get eventually have to pick up the bill for the currency risk associated with lending to the US in dollars at low rates …

* In one key respect the scenarios do differ: the collapse of the balance of financial terror would push Treasury yields up. The credit crisis has pushed Treasury yields down.
** If a US money market fund shifted from investing in Treasuries to investing in the dollar denominated paper of a European that was “funding” its holdings of mortgage-backed securities in the money market, the money market fund effectively ended up taking on credit risk – albeit quite indirectly. A money market fund that shifted from holding Treasuries to holding Lehman paper certainly ended up taking on credit risk.

94 Comments

  • Posted by zebla

    right, thanks

    so, what will take place now?

    to what will look like the end of the film?

  • Posted by DJC

    Bretton Woods 2 is still well alive and kicking. Despite staggering budget deficits and a collapsing civilian industrial base, the US Dollar remains at a 1 year high versus the Euro. US Dollar hegemony for global trade remains intact with the petro-dollar “de facto” backed by US military projection power. In exchange for security protection of the respective regimes, Saudi Arabia and the Arab Gulf states continue to export the strategic commodity oil for sale exclusively in petro-dollars. So no matter how large the US trade and budget deficit, strong global demand of US petro-dollars continues unabated. Ironically, the worse the recessionary global economy, the greater the capital flight to US government Treasury bonds which increasingly misallocates global capital. The pool of US real savings has been long depleted, but the rest of the world is forced to continue to provide its savings to the US Economy.

  • Posted by jboss

    There is another scenario that can happen:
    China etc. financing a complete infrastructure overhaul in USA/EU.

    That would be a policy decision. But given policy priorities in Europe and the Obama camp it’s pretty reasonable.

    There is not such a big difference between building homes and building wind parks/ solar thermal installations/ electricity lines.
    We’re still talking about economy restructuring on a large scale, but it’s at least doable.

    All of these installations are even in China’s national interest, since they lower demand pressure on certain commodities on a long term basis and they will provide a model to copy for a step, that China too one day will have to take. And they have an expected payoff and can therefore be considered hard assets – useful to maintain the national credit score.

    In practice this means that this emerging industry will be split: local builders and management (ok, maybe Indian management) and a high share of imported Chinese components.

    The ball is in the policy field, but you might still be wrong after all.

  • Posted by 3.1415

    Without hegemonic power, BW2 will be gone instantaneously and US will probably break up into quite a few independent states, speaking various dialects of English or Spanish. The real question is how long BW2 can sustain the American Empire? It sounds like a chicken and egg sort of question. The Empire needs a lot of cash to flex its muscles. It looks like that China is doing more and more to increase domestic demands and makes its socialism catching up with its evil but successful twin brother. The financial crisis forces China to quit its addiction on export economy. The Chinese leaders seem keen on using this opportunity to make China stronger with intrinsic strengths. As China looks inward more, there is less and less reason for China to buy the US fiat, either for profits or to keep its currency down. It is just a matter of time for BW2 to collapse. Predicting the exact time of death is difficult and not quite meaningful. But it will be a bang, not a fizzle, as US will try as hard as possible to squeeze its cash cow.

  • Posted by Cedric Regula

    jboss:

    I still think it’s more likely China does that in China.

    Brad:

    I really don’t see any reason why we wouldn’t first have the private banking crisis, and then secondly the collapse of the balance of financial terror. Kind of like the Roadrunner & Wile E. Coyote cartoons where the coyote goes off a cliff, hits one ledge, it breaks, then down to the next ledge, the prior ledge crashes down on his head, breaking the next ledge…downward to the next ledge etc…

    Almost seems like we would with a $11T deficit to re-finance, no reason for vendor financing to do that at low rates, re-pricing up of treasuries, probably increasing spreads on everything else, HEW defaults, further home price deflation due to higher mortgage rates….economy could get bad…less and less wealth in the stock market to drain for us locals to buy treasuries….

  • Posted by hcash

    DJC: I’m curious why you feel that the pool of real savings have been long depleted? Do you mean this in an Austrian economics sense? It seems to me that many people have plenty of real savings, defined by me to be real stuff like a home (deferred consumption of housing), a few autos, claims on value creating businesses (apple or google stock), full ownership of value creating businesses (a farm or an engineering company or a doctor’s office), and resources (we have an abundance of natural resources- tapped and untapped). I will grant that finance has grabbed too large a proportion of our economy recently but that is changing and the pool of real savings will be left. I still think it’s the largest in the world.

  • Posted by Cedric Regula

    hcash:

    Latest estimate of personal net worth in the US is about $56 trillion. That is mainly in real estate and stocks & bonds. I think that may go down maybe 20% tho, since the estimate is from last year.

    However 30% is distributed among 3% of the US households.

    But we are not all broke yet.

  • Posted by DavidHK

    Brad, nice analysis!

    In my last trip to Southern China, I heard a lot of stories about how hard it is now in the export industry, especially around cities like Dongguan and Shenzhen. Chinese exporters are hurting!

    But the currency loss is less tangible. Isn’t it just paper loss? The reserves are sitting there and doing little in any case. China doesn’t have to raise taxes to pay for those losses. Most of China’s savings and tax revenues are demoniated in RMB, which are larger than the reserves. I don’t really see much effects of such currency loss on either Chinese economy or China’s public finances.

    Or am I missing something?

  • Posted by baychev

    so bluntly said China is a mercantilist feud poorly run by communist apparatchiks.

  • Posted by bsetser

    The currency losses reduce the profits of the PBoC, and thus can be thought of as a tax on china — the government isn’t getting the seignorage revenue that would be expected. that is a bit more than a “paper” loss. no one would say that the USG is just taking a paper loss if it buys assets under the TARP for $700b and sells them for $500b.

    the other big loss comes to all Chinese savers (notably households) who have accepted low nominal (and negative real) interest rates on their vast deposits as part of this policy. China has kept the PBoC’s costs down by shifting costs to the banks, and helped the banks by keep deposit rates low (And lending rates high).

    Jboss — if some of the Chinese inflow could be redirected into investment in alternative energy, that would indeed be a win/ win. Some infrastructure bank style ideas have promise in my view — basically, the flow that used to go to freddie/ fannie could go to wind farms and the like. I would rather see more adjustment in china (i.e. more investment in Chinese infrastructure) but during the transition, if there is one, to a lower Chinese surplus, redirecting chinese financing toward new energy tech would be offer real benefits.

  • Posted by bsetser

    DavidHK – note that net exports contributed positive to Chinese GDP growth in q1, q2 and likely q3 (the world bank is crunching the numbers, but the nominal surplus went up not down). this isn’t to say that real export growth hasn’t slowed — or that it won’t slow more. only that in aggregate real exports are still growing — and that it is also important to look at real imports. the low end Chinese producers are facing pressure in part b/c China has moved upmarket, and is exporting more higher-value added stuff (which big up wages for a while).

    of course, looking backwards is dangerous. looking forward, chinese real exports and real imports both could start to fall — i.e. they would no longer be able to drive Chinese growth/ modernization as the BW2 thesis postulated.

  • Posted by TJ

    The latest update from the Bank for International Settlements (BIS), in September reports the total notional amount of outstanding derivatives in all categories rose 15% to a mindboggling $596 TRILLION as of December 2007. $600 TRILLION dollars is about 20 times the GDP of the USA and EU–combined! Tough times ahead, not only in America, but globally.

    http://www.bis.org/publ/qtrpdf/r_qa0809.pdf#page=108

  • Posted by baychev

    Cedric Regula,
    household net worth is not quite what you see. just imagine a dump of $1tn of treasuries from the chinese and you will quickly realize that your net worth is close to … worthless.

    i will give you another less stinging example: germans thought their stock market appreciated 20% in 2007. but this was only so due to the huge influx of u.s. buyers. now their market is much lower and on top of that the currency is cheaper.

    your net worth is approximation to liquidation price, not prevailing market price of a small example.

  • Posted by Cedric Regula

    Jboss,Brad

    China likes 3rd generation nuclear power. Safe, lower cost than NG or coal, very much lower cost than coal with carbon sequestering, and zero carbon footprint.

    Wind is about 4X more expensive than our electric costs now. That’s in an area with consistent wind. Solar is worse.

    I don’t know if we can sucker them into investing in our technical fairy tales.

    Here’s a easy primer on 3rd gen nukes.
    http://nuclearinfo.net/Nuclearpower/WebHomeCostOfNuclearPower

  • Posted by Cedric Regula

    baychev:

    Understood. I think about that constantly.

  • Posted by DJC

    hcash,

    The US national savings rate remains in negative territory with a -3% savings rate. The pool of US real savings have been long depleted in the sense that money that really isn’t there is called this – CREDIT. The credit bubble implosion is collapsing the entire US Economy. All of this just proves that the US bubble economy was simply an ponzi ILLUSION perpetrated by Wall Street banksters!!! There remains little “real wealth” industrial production left in the United States.

  • Posted by LB

    jboss — that is a brilliant point. i kept wondering when somebody was going to bring this up. brad is right — win/win.

    btw, solar thermal installations are so easy & affordable to retrofit onto existing structures, it’s amazing that there aren’t more of them here…until you realize that they work to decentralize energy.

    cedric — china is already doing it in china. they are way ahead of the curve over there. my partner brought back some photos of shanghai — rows of middle class homes each with a small solar panel on top. and that’s just the tip of the iceberg — an architect friend just came back from beijing and wants to move to china (he’s into designing self-powering structures and is incredibly frustrated by the bureaucracy and cost-prohibitive measures in the US).

    davidHK — a small example to illustrate your point. my partner has a clothing business and had her friend from high school who runs a textile producer make some of the clothes last year. she kept wondering when her friend was going to send her the payment invoice.
    the bill came yesterday.

  • Posted by LB

    cedric — i know you have a jones for nuclear, but there are numerous reasons why solar/wind power is 4x more expensive in the US and most of them have very little to do with pure economics.
    BWII is one of those reasons.
    the insistent myth of the need for a ‘national grid’ is another.

  • Posted by Obey

    Brad- how solid is the assumption that there will ultimately be a loss for the Chinese to realize? There will only be a loss insofar as the Yuan rises whilst BWII unwinds. Is there not a case for a relative rise in the dollar? US deflation and rising exports vs Chinese inflation and maintenance of negative interest rates would seem to be a scenario which gives the Chinese just that…

  • Posted by Cedric Regula

    LB:

    We are doing it here. People just don’t like to talk about the performance.

    San Fran has a solar farm…costs are 8 cents/kwh vs about 2.5 cents (gen cost plus transmission cost) for conventional electricity. But only when the sun is out, which raises questions in my mind about how they are amortizing costs…

    Distributed sounds nice but those rooftop panels only make about 200 watts, when the sun is out at noon in the summer time, and if you crawl up on your roof to regularly wash them.

    These systems have been getting state , local and federal tax breaks. No one has been trying to make them more uneconomic.

    At my parents HOA pool in Florida they installed a solar water heater. The pool water did not get warm, and they went back to an electric pool heater.

    They have created a shortage in semiconductor grade silicon.

    There is the mirror/Stirling engine approach and a full size plant is running in San Bernardino, CA sponsored by the DOE. Slightly better cost but not much. Cap cost is hard to amortize when you can’t do it 24 by 7.

    T.Boone Pickens is spending $10B on a 4000kw windfarm. A natural gas plant that size costs about $1 billion.

    This may in total supply 5%, maybe 10% of our generation and going beyound that will just be more misallocation of capital and we can’t really afford to keep doing that.

    And if we did want to increase electric generation to support plug-in hybrid and all electric vehicles, which is a very good idea since electric vehicles have triple the efficiency of gasoline vehicles, nuclear is the only way to get there with a zero carbon footprint.

  • Posted by Quarrel

    Brad,

    One of the potential advantages to this sort of breakdown versus your original scenario is where the fingers get pointed (ie political).

    It would have been very bad if we get to a point where foreign govs stop lending to the US, and the US starts feeling like throwing its weight around (whether through trade, military, whatever), or if the US stopped taking the gifts (as you put it) and that led to major collapses elsewhere.

    The current breakdown may still lead to nasty side-effects (although hopefully not the depression era style trade barriers), but hopefully it will force a re-evaluation of BW2 in a more co-operative manner. Everyone will be feeling the pinch.

    Just as with breaking with BW and the floating of rates, the crisis could lead to long term solutions, even if they do have to be swallowed as unpleasant medicine.

    –Q

  • Posted by fatbrick

    I am with Cedric Regula her. Wind and solar are actually more expensive and I do not see how they can become economic in the future. I doubt the technology progress can do anything about it.

    Nukes on the other hand pose a real opportunity, 24/7.

    One small piece is geothermal, which is 24/7 and cheap in operation. But it is has some limitations too.

  • Posted by Cedric Regula

    fatbrick:

    I went to engineering school right after the Arab Oil Embargo, and alternative energy was a hot topic then. All the same stuff you hear of nowadays. They even offered entire courses on it , which I took. Then my first mini career was in the power plant biz, before Volker killed it with interest rates and the Saudies killed any interest in alt. energy with their big oil field discovery.

    For the last 5 years I’ve been researching what’s changed, and it is frighteningly little. Solar cells are still expensive and only have a 15% conversion efficiency. They developed the new cost reduced film technology, but that knocks down efficiency to 7%.

    Wind power works where there is wind constantly. Generators are mature technology and are already 90 some percent efficient.

    Geothermal, tidal, ect. work where they are available.

    Looks like coal gasification and synfuel is out because it makes too much CO2.

    Good news is 3rd gen nuclear is way better than 1st gen plants.

    Hybrid cars are good, and battery technology is finally getting barely good enough for all electric cars to be practical.

  • Posted by RebelEconomist

    Charles Dumas’ estimate of the losses on China’s reserves is way too high.

    The return should properly only comprise a currency return and an investment return (in the long run, the inflation differential should be reflected in the exchange rate movement). Since July 2005 when the peg began to be allowed to crawl, the renminbi has appreciated by about 6% per year against the dollar, not 10%. Even now, only the shortest of US treasuries yield less than 2%, and the Chinese reserves no doubt include higher yielding agency bonds, MBS etc (although such spread product will have taken capital losses, these will be offset by capital gains on treasuries) plus other, higher-yielding investments in currencies such as the euro. So the return on the Chinese reserves portfolio should be 2% at least. China’s reserves are effectively funded by sterilisation bills, on which I have no good information, but should yield no more than about 6%, based on the official deposit and lending rates, implying a net investment loss of 4% at most. So a conservative estimate of the cost of maintaining China’s reserves is about 10% per year, not 15%.

  • Posted by alan greenspend

    Nicely done Dr. Setser, your joint seminal paper with in 04 was a huge motivator for me. Highly leveraged derivatives trumped vendor based financing after all.

    But to stay on topic as opposed to sustainable energy, President Bush is coordinating a meeting on what might replace Bretton W2 in a few months.

    Ummm, yikes.

    It’s difficult to postulate anything useful coming from that. I can see only conflict as each group picks alignment.

    Thoughts?

  • Posted by Fewlesh

    Cedric Regula,

    Nanosolar:
    They can print miles of it, and it’s cost
    competitive with coal (w/ sunlight).

    They are currently in their early ramp phase. They are a utility scale solar company.

    No 1 technology is the silver bullet. Energy must die of a thousands little cuts.

    Back to the regularly schedule financial discussion.

  • Posted by LB

    cedric — TBoone’s wind farm et al is simply creating another energy monopoly under a green meme. i agree, not practical or efficient.
    and yes, current solar technology under what most people consider technology is a waste of resources.
    but there are other ways to collect energy from the sun that don’t use silicon. simple ways that have been used for hundreds of years that can be drastically improved with simple ingenuity.
    don’t know about your parents’ HOA solar heater, but just having it installed and expecting it to work like magic might have been part of the problem. these things take tweaking to get them to work most efficiently.
    and therein lies the large gulf of misunderstanding imo, we as a people have forgotten how to ‘get under the hood’ and get our hands dirty in order to provide ourselves with the basic necessities of modern life, when perhaps some of the answers lie right under our noses.

    this is one of the unfortunate byproducts of globalization as currently organized under BW2.

    perhaps the next incarnation will allow for innovation, ingenuity and creativity to be dispersed across a wider range of the world’s population rather than following an inverse relationship to capital flows.

    one can always hope, yes?

  • Posted by James Buchal

    Isn’t the push for government-driven investments in renewables yet another gigantic misallocation of capital, akin to the government’s ventures into mortgage financing?

  • Posted by LC

    I am curious as to how you reach the conclusion that US imports will fall following this crisis. For all the past recessions that I can remember, the trade deficit worsened for the US. It’s due to 1.) US dollar strength vs. Eurozone 2.) subsitution effects. The same factors seem to be present this time also, so I don’t quite see why imports will fall drastically.

  • Posted by Cedric Regula

    Fewlesh:

    There is some some bleeding edge stuff out there. Here’s another existing tech idea, just more efficient use of material. Hopefully we find out soon how it all works.

    http://news.mongabay.com/2007/0221-coolearth.html

    Actually, I think this stuff does sort of have something to do with BW2 and trade deficits, but we’ve probably covered it adequately for now.

  • Posted by Nice Job

    Brad: Nice Job….how come you are not a currency trader?

  • Posted by layman

    general question from a layman:
    why does the treasury need to issue paper to fund the TARP, hence risking higher borrowing costs? what prevents the fed from printing infinite money and sustaining the financials indefinite? by-laws? regulations?

  • Posted by canadian abroad

    Pardon a dumb question, but faced with slow growth worldwide, why would China want to fund an alternative energy infrastructure here rather in their homeland?
    Even if US innovation were a magnet for investment, actual production would likely still be in China.
    Even if an Obama administration spends a trillion on windmills, wouldn’t the borrowed money to do this come with strings attached? The rest of the world has undoubtedly learned the lessons of development aid programs…

  • Posted by DJC

    Economist Marc Faber: Taxpayer Bailout of Wall Street Banks is a Waste of Money

    http://www.cnbc.com/id/27295113

    The $700 billion US financial rescue plan might give the market a temporary boost, but eventually stocks will fall again, Marc Faber, the analyst know as “Dr. Doom,” told CNBC.

    Faber, editor & publisher of “The Gloom, Boom & Doom Report”, said he doesn’t believe that the recent efforts to ease the global credit crisis will help.

    “It will work temporarily in the sense that some confidence is coming back into the market,” Faber said about the bailout plan. “First we’ll get the bounce from an oversold level and I suppose afterwards it will drift because the global economy is decelerating at an unprecedented pace, and the governments in the Western world they try to reignite credit growth, and I think it will fail.”

    “The U.S. produces very little,” he said. “Asia is the producer for the United States and it is also the region that has very large capital spending. So when there is a slowdown in the U.S., it’s basically a disaster.

  • Posted by ReformerRay

    Dependence of the world trading system on U.S. consumption of imports should cease.

    If that kills Bretton Woods II, so be it.

  • Posted by bsetser

    q: Why am I not a currency trader?
    a: I don’t like waking up at 5 am!

    and I also probably wouldn’t be very good at it; my risk tolerance is rather low.

    layman — the us would rather not go the route of printing money; it isn’t good for your credibility/ the currency etc. and if you can borrow at low rates, you don’t really need to run the printing presses.

    LC: I base the forecast that imports will fall based on the incoming data on personal consumption. and moreover, the fall in oil prices will certainly reduce nominal imports. to me the big question is whether imports will fall significantly more than exports. the rise in the $ — if sustained — will have an impact, but with a lag.

    Rebel — Dumas may be on the high side, and the ultimate cost hinges on the ultimate RMB appreciation v a EUR/ USD/ JPY basket (ergo deflation in the US and inflation in China would reduce the PBoC’s losses, tho it would produce other costs). the long-term cost depends on:

    a) the RMB’s appreciation
    b) the gap between RMB rates and US/ EU rates (now not in China’s favor — as Chinese rates are above US rates at the short-end, but China issues short and lends long, helping it)
    c) the extent to which the PBoC keeps its costs down by keeping Chinese rates too low/ shifting some its costs to depositors.

    I am fairly comfortable that the subsidy implicit in China’s current policy is somewhere between 3-5% of China’s GDP — depending in part on how much capital makes it into China to benefit from the currency play.

  • Posted by ReformerRay

    Consumption of imports in the U.S. should be restricted by law to those countries that do not have a large trade deficit with the U.S.

    Equal trade between countries should be the goal of all international trade.

  • Posted by ReformerRay

    I am able to add, if I keep my comment limited, but I sometimes type “deficit” when I mean to write “surplus”.

  • Posted by Twofish

    canadian: Pardon a dumb question, but faced with slow growth worldwide, why would China want to fund an alternative energy infrastructure here rather in their homeland?

    Answer. They wouldn’t. Right now the 17th Party Central Committee Plenum is meeting and it appears that the economic policy that they are coming up with involves massive spending on health and education projects mainly directed at rural regions.

  • Posted by David Heigham

    It was a bit like spillikins. We could see that when one key stick went, the whole bunch would go down; but we did not see what tweaks to some of the other sticks might do.

    However, the important prediction was that the bunch of sticks would collapse. You got that very uncomfortably right. I was among those who thought that policy would change sufficiently before collapse happened. We were wrong.

  • Posted by ReformerRay

    I am happy to see the collapse of Bretton Woods II.

    First post above says “What happens now? What is the end of the film?”

    The end of the film is a world trading system without the U.S. as the dominant consumer. Equal trade will become more nearly the norm.

    I my book, equal trade should be the ideal, in addition to the norm.

  • Posted by Nice Job

    Assuming your 3-5% subsidy is correct – what is the point of growing at double digits? wouldn’t it be better to grow 7-8%, not subsidize “outsiders” and let your people enjoy the benefits?

  • Posted by glory

    …and yet despite it all, the US can still borrow below 5%; maybe i’m heading into twofish/mastercard territory, but being the world’s sole military superpower really is priceless…

  • Posted by jboss

    Nice Job:

    Subsidies make sense, if a young growth industry is enabled to reach economies of scale quickly. By subsidizing exports generally, China could grow a huge industrial core over a wide range of products with strong network effects.
    It was brilliant policy to get into business in the first place.
    The question is: Why should they continue to do so?
    And the answer is: they shouldn’t, as long as there is not a new promising industry they want to dominate.

    They especially have no reason to continue this little game, if they perceive global demand to be artificially blown up.
    It’s valuable to have an industry, that is a global leader in production capacity. But it’s deadly to have an actual production surplus.

  • Posted by Twofish

    Nice Job: Assuming your 3-5% subsidy is correct – what is the point of growing at double digits? wouldn’t it be better to grow 7-8%, not subsidize “outsiders” and let your people enjoy the benefits?

    Maybe not. China is saving up lots of excess capital for the coming aging of the country, and it has far more capital than it needs. Dumping it all into US Treasury and agencies, seemed to me the “least bad” place to put that savings given all of the alternatives, although this may be changing.

    If the money had been kept in China, you’d either up boosting consumption which is a bad thing to do in a boom, or giving the money to chronically ailing banks, which is a bad thing to do, because that removes any incentive for the banks to change their behavior while there is any chance that the behavior can be changed.

    So personally, I think that China did the right thing from 2003-2008. However we are now in a new world.

  • Posted by JKH

    Brad,

    I’m not sure whether you’re associating the end of BW2 with the too-abrupt unwinding of imbalances, or the abrupt unwinding of pegged FX rates, or both. For example, I can see the first happening possibly without the second. It’s not clear how disconnecting RMB from BW2 would be China’s logical response to a collapse in US imports. That said, my sense is that the outcry for a new world financial order, perhaps including BW2 transformation, has been motivated by the global banking crisis more so than global imbalances, although imbalances have obviously been a major catalyst for the banking and credit crisis, as you describe.

    Much has been written lately about “maturity transformation” as an essential risk underlying the banking crisis. The “two things” to which you refer constitute a sort of BW2 facilitated “credit transformation” and “vendor finance transformation”. This created a global mal-distribution of US dollar asset risk, with foreign central banks holding low credit risk US dollar assets (low risk by asset type, not by currency), and the US domestic private sector holding relatively high risk US dollar assets. The shortage of low risk assets available for domestic investment may have contributed to the manufacture of synthetic “low risk” product such as super senior CDOs, etc., priming the pump for the eventual credit melt-down. The low risk dollar asset profile held by foreign central banks is also offset by the high risk inherent in the dollar as a currency. The salient point I think is that the foreign central bank asset risk profile has been an aberrant risk-averse departure from a more typically balanced asset risk strategy, notwithstanding the US dollar currency exposure that exists whatever that choice.

    Ironically and perhaps pathologically, the US Fed and Treasury intervention has now manufactured a “rebalancing” of this global credit risk profile in the sense that additional USG financial obligations are being created via Fed initiatives, TARP, et al, in order to replace/transform high risk US dollar assets held by the domestic US private sector to low risk ones. And the Fed/USG asset initiatives don’t directly create additional foreign financing requirements. The combination has the effect of diluting the US credit risk impact of BW2. At the same time, US private sector credit risk adjustment is being transferred to the US taxpayer, while US dollar currency risk remains a threat.

  • Posted by bsetser

    JKH — I more or less agree with most of what you said, including the notion that the US taxpayer is now playing the role in the system formerly performed by the US financial sector. I basically tried to argue that if US demand fell fast enough (b/c of the collapse of the banking system) BW2 could end in some fundamental way (US and EU demand isn’t growing, so it isn’t supporting exports in the emerging world) w/o an end to dollar pegs …

    that certainly wasn’t my initial thesis back in 04/05 — but it seems that something that i didn’t imagine might well trigger a variant of something nouriel and i did imagine (a sudden stop in US consumption that pushed the US back toward BoP equilibrium)

  • Posted by don

    I continue to believe that the death knell to BWII will come when developed countries insist on keeping their own demand and discourage currency mercantilism.
    China needs the reserve build-up, because any alternative way to stimulate growth is just not there. Think of the corruption and misallocations involved in any public works projects.
    Pre-war Germany used the arms buildup to get fiscal stimulus. The U.S. and its allies didn’t have sufficiently strong fiscal stimulus to get out of the depression until the war started. It was surely possible to get the fiscal stimulus some other way, but apparently government simply did not have the imagination to institute the dramatic government spending increases that were needed. .
    Given the lack of alternative measures, I don’t think China is losing anything by its reserve accumulation. I think a proper construction of the counterfactual would show that their total wealth would be lower with the next best alternative to the reserve buildup.
    Why suffer the reserve buildup to produce double-digit growth? That is the wonder of Keynesian economics. The nation’s wealth can be improved with production that is dumped into the ocean. Extra growth of 3% bought by wasting 3% of output means that you just break even. An extra 4% of growth bought by wasting 3% of output puts you ahead.

  • Posted by Howard Richman

    Don writes: “I continue to believe that the death knell to BWII will come when developed countries insist on keeping their own demand and discourage currency mercantilism.”

    That’s exactly what we propose in our commentary that was posted this week in Enter Stage Right: http://www.enterstageright.com/archive/articles/1008/1008buffet.htm

    We advocate that a new system replace the current system, one based upon balanced trade which benefits all of the countries who engage in it. Furthermore, a balanced trade system is sustainable.

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

  • Posted by jboss

    “Balanced trade” between absurdly rich and absurdly poor countries is a joke.
    Have you ever been to China or India?

    We are talking about 40% of the world population, including a lot of really smart people.
    If these countries will one day represent 40% of global GDP, it’s only fair.

    “Balanced trade” is just a chiffre for romantizising poverty (“They are poor, but they are happy.”) or even worse, belief in Western superiority.
    Both countries will grow a competitive industrial core with time. During that growth phase “unbalanced trade” helps them a lot. Once they reach developed status things will change.

  • Posted by ttnk

    Beg to differ;

    It is not the BoP`s “linear dynamics” or their “structural moralities” / legalities, but the mythical D-hole that evaporates BW2 infrastructure, thus BW2 itself. If right (it seems there is NO ONE else agreeing), there is a simple-enough, hey, nonlinear solution around: convert the debt of infrastructure’s institutions to their capital without getting to fiscal about it. Since the fairies erected the D-hole in the first place and then got lost in space of fractal dimensions that “jumped out”, the proposed solution seems to largely surpass the combined fairies (linear) ability to grasp, hmmm, accelerating dynamics of reality?

    Once upon a time, there was a simple enough ceremony in Fairyland; from time to time the one who owes went to the one that lent and they both sat down and agreed on what to do. It is especially Mythical why this does not occur, since the latter wishes both of them – not to turn gnomes (wants, fully aware of the implicit un-productiveness, to lend more of its savings to the former).

    Instead (of propping up the infrastructure enabling the continuation), the fairies, while deflating the “private sector credit risk”, plan to explode the “currency risk” in the rest’s faces…
    …and then wonder what was it that evaporated their, previously well known, “ability” to mythically restart the cycle.

    Since the fairies took over, it became the Intellectual (not the “this and that assets”) Bubble, that’s obviously been deflating the most, so the other department (the one with “Preventive Action” title) of this tank will, unfortunately, get to think a lot and go real busy real fast.

    Fairies, please, get a grip on yourselves, before we all turn gnomes.

  • Posted by satish

    What’s going to be effect of pakistan bankruptcy?
    Will they invade strait of hormuz if they go bankrupt?

  • Posted by LionelR

    Pakistan goes bankrupt, some crazy regime comes to power, and they block the straits of Hormuz? That’s just the kind of way in which an economic crisis can lead an international political one – and has done so in the past. Economists like Keynes, who were acutely aware of the political consequences of economic conditions and policies (as well as of the economic consequences of international political arrangements, such as the Treaty of Versailles), were motivated in part by the desire to lay what the young Keynesian James Meade in 1940 wrote about as “an economic basis of a durable peace”. This was a major driver for Bretton Woods mark 1! (All this is discussed in “John Maynard Keynes and International Relations – Economic Paths to War and Peace” by Donald Markwell, published in Oxford in 2006.) Part of why Keynes wanted the simultaneous international pursuit of Keynesian policies was to overcome the pitting of the economics interests of one country against another. Fairly important to remember that now!

  • Posted by TTS

    Moral of the story:
    Chinese labor toil and toil to help build up Forex rserves and these in turn are invested in US debt with low yields.
    US consumers benefit and enjoy a higher standard of living to the detriment of Chinese consumers.What is the point of all this?Are we
    human beings??

  • Posted by don

    Jboss has a point: “‘Balanced trade’ is just a chiffre for romantizising poverty (‘They are poor, but they are happy.’) or even worse, belief in Western superiority.
    Both countries will grow a competitive industrial core with time. During that growth phase “unbalanced trade” helps them a lot. Once they reach developed status things will change.”
    Taking from the poor so the rich can have more is questionnable on moral gounds. However, aggregate demand is scarce, and as King Richard noted, it is harder to accept less from having more than to accept less of an increase. So, I wouldn’t depend on pity from the developed countries to sustain BWII when the going gets really tough and their living standards are set for a drop.

  • Posted by s

    jboss Says: is there a case in human history when someone coorperated in their own demise?

    ttnk Says: same logic applies

    The problem here is not the rest of the world. The US is merely acting to protect its self interest and pulling the other along by playing victim. Fund us or else. BWII is doomed. Seems reasonable to assume that the US will eventually agree to a loss with dignity. Either way they spin it the US is the loser, despite the mythical dollar rally.

  • Posted by john

    Re: DJC’s first comment.

    I agree. What is not factored into the “value of the dollar” talk is that the worse the world situation gets the better it is for the dollar. The nobility-scum that currently owns the world (and always have owned it and always will own it) know that the US has the world’s most loyal and patriotic (meaning delusional) peasant army. And, more importantly, the US peasant believes – with his whole heart – that it’s worth dieing to protect the wealth of HIS American nobility. And BEST of all – for the foreign nobility, the peasantry is way too ignorant to understand that the American nobility is open to anyone with enough dollars.

    The scum of the earth will continue to seek safe haven in the US – with their dollars – protected by the patriotic American peasants. Mission Accomplished!

  • Posted by s

    Enough about Keynes already. Hsi track record is dubious, despite the idol worship in university (and or left).

  • Posted by gillies

    DC – if the dollar is supported since the 1970s by a secret agreement that oil can only be priced and bought in dollars, should the dollar not be sinking now as the oil price goes down the sump ?

    and if we are lacking only the hyperkeynesian dollar drop – when do the helicopters arrive ? we seem to be running behind schedule . . .

  • Posted by Twofish

    DJC: Despite staggering budget deficits and a collapsing civilian industrial base, the US Dollar remains at a 1 year high versus the Euro.

    In fact latest news from Hong Kong is that Citic Pacific has lost about $2 billion from betting that the RMB would continue to appreciate against the USD.

    I remember someone asking why anyone would sell options against a falling RMB or low oil prices when it was obvious to everyone that the RMB would continue to rise and that oil prices would keep going up. Well….

    It’s the “sure bets” that will get you in a lot of trouble.

    TTS: US consumers benefit and enjoy a higher standard of living to the detriment of Chinese consumers. What is the point of all this?

    It’s actually not to the detriment of the Chinese consumer. The Chinese consumer is saving large amounts of money for retirement, and the individual consumer is not likely lose money via currency losses.

    Even if China does take a hit with respect to foreign exchange rates, the individual saver is not going to see their bank deposits directly reflect this loss, since the government is on the hook for any currency losses that result.

    Near zero return for retirement savings looks really silly in boom times. However right now near zero return (or even slightly negative) returns for retirement savings looks really good now.

  • Posted by FG

    twofish: even slightly negative) returns for retirement savings looks really good now

    I’m struggling to understand your comments: why are “slightly negative” returns a good thing, when they could make positive returns by investing in China or even just 0 returns by leaving the money in the bank doing nothing?

    And if you save for retirement, it’s a long term plan… but what China is doing makes sense only in the short term, unless they are hoping for a miracle along the way.

  • Posted by chegewara

    it’s about time people start thinking about china in less exalted terms. capex ratio is going to collapse, unemployment is already surging and banking system is creaking. “savings” conundrum is not a virtue, but instead what is called a “financial repression”, a huge tax on the populus. chinese banking system will need a huge bail-out and people will flee remninbi. china is a huge part of the problem, not a part of solution.

  • Posted by Twofish

    FG: I’m struggling to understand your comments: why are “slightly negative” returns a good thing, when they could make positive returns by investing in China or even just 0 returns by leaving the money in the bank doing nothing?

    Slightly negative returns can be a good thing if the alternative is the risk of wildly negative returns.

    Also, there is no such thing as a bank doing nothing with money. If you give a bank money they have to do something with it.

    FG: And if you save for retirement, it’s a long term plan… but what China is doing makes sense only in the short term, unless they are hoping for a miracle along the way.

    We have to split things up a bit. When you mean “what China is doing” you have to specify exactly who in China. The individual saver, the State Council, the banks, and the PBC are all doing different things with different motives, and when you put all of it together what comes out sort of makes sense to me.

    For example the individual saver is putting money into the checking account with the expectation that they are going to be able to withdraw the same RMB amount out again. They really don’t care about foreign exchange losses as long as they get out the same amount of money they put in.

    Most of the savings goes into relatively low yielding, but more or less safe securities, which is basically what Social Security does. The return on investment for Social Security trust fund is 3% for the average worker.

    The problem is that if the securities yield very little, then you are going to have to save massive amounts in order to have a comfortable retirement, which is precisely why saving rates are so high.

    What worries me about the United States is that most people are saving for retirement assuming that they can put money in the stock market and get out 10% annualized returns in their 401(k). If that turns out not to he the case then we have some large problems.

  • Posted by Twofish

    chegewara: it’s about time people start thinking about china in less exalted terms. capex ratio is going to collapse, unemployment is already surging and banking system is creaking.

    Yes, yes, and yes. The question then is will this lead to a systemic crisis and I think the answer is no because…..

    chegewara: “savings” conundrum is not a virtue, but instead what is called a “financial repression”, a huge tax on the populus. chinese banking system will need a huge bail-out and people will flee remninbi.

    Over the last few years, the Chinese government has done a “preemptive bailout.” By forcing lending rates to be much higher than borrowing rates, what this means is that the banks have a lot of liquid cash, so when things start falling apart, the cash is already there to absorb the losses.

    “Financial repression” is a term that people used to make what the Chinese government was going sound bad, but a lot of the people who were against it are now looking for work.

    chegewara: china is a huge part of the problem, not a part of solution.

    China’s been spending the last eight years doing what Western governments should have been doing which is worrying about what happens to the financial system when the boom ends.

  • Posted by Judy Yeo

    Everything has a certain lifespan, mebbe immortality was never a good idea, even for financial systems?!

    ooh, anyone saw tyhe precipitous decline of the euro and the pound, yikes!

  • Posted by Michael

    Brad,

    It’s not an either/or. You were right in 04/05 AND you are right now. Your post is the best short summary anywhere of the direct relationship between the trade imbalance/dollar flow and the growth of risk-heavy overlending in the U.S. (housing mostly, but not only).

    The chicken-egg relationship between foreign debt subsidy to the U.S. and the explosion of U.S. housing debt, created a new capital flow process that has been increasingly unstable for years. It took advantage of BW2 to let U.S. credit creation go nuclear, but BW2 does not bestow U.S. debt immunity from credit and forex consequences for all eternity.

    Obviously, if the Treasury creditors had begun the unwind by demanding higher rates, that would have been a trigger for the housing-initiated banking crisis. But at the level of instability we had reached, any of many different things could precipitate a collapse at either end of the capital flow. The banking overleverage/underestimation of risk could have fallen apart first (and did), or the capacity/willingness of foreign creditors to subsidize our debt could have slowed or ceased and started the collapse.

    It amazed me during the last decade to watch the myriad ways the growing credit instability was pooh-poohed (e.g., Greenspan’s famous statements). The idea of a credit collapse was not considered realistic in the New Paradigm of spread-everywhere risk and permanenetly-imbalanced international finance. Now, it amazes me to watch the myriad ways the growing instability of U.S. Treasury financing is pooh-poohed.

    Just as the apologists for the crazy over-leveraged risk-taking by banks (and others)used the fact that the profits were obviously fabulous and the borrowers just kept coming as “proof” of the sustainability of the process, the apologists for massive Treasury printing to aid zombie banks and evade deflation use the fact that Treasury prices are fabulous and the lenders just keep coming as “proof” of the sustainability of the process.

    When you hear the question asked, “Where will the next bubble be?” you already should know the answer, because it’s right in front of you. Treasuries as an asset are in a price bubble comparable to stocks, housing, and commodities in their turn. The arguments for why it makes (short-term) sense for capital to flow into the Treasury bubble are no different than the arguments for why it made sense (at the time) for capital to flow into the the other assets during their bubble times; and the ending will be the same.

    Shorter-term thinking, whether driven by greed or fear, produces the same result: a longer-term outcome you really don’t want. Not only is the banking crisis consistent with an eventual unwind (slow or crash-speed) of the balance of financial terror, it will eventually lead directly to it.

  • Posted by Howard Richman

    I wrote: “[In our Enter Stage Right commentary ( http://www.enterstageright.com/archive/articles/1008/1008buffet.htm ) we] advocate that a new system replace the current system, one based upon balanced trade which benefits all of the countries who engage in it. Furthermore, a balanced trade system is sustainable.”

    JBoss and Don disagreed. They argued that imbalanced trade is necessary in order for poor countries to develop.

    They are mistaken. Imbalanced trade is produced by the combination of export-oriented strategies with import-reduction strategies, a policy known as “mercantilism”. Only the export-oriented strategies are necessary for economic development.

    The problem is that mercantilism impoverishes the mercantilist country’s trading partners. It only enhances development for a short time. It is not sustainable because it eventually ruins the market for its products. We are seeing the result in the current recession or depression.

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

  • Posted by Kaiane

    Does that mean that all of us responsible savers with plenty of cash on hand will now be “rewarded” with higher interest rates on our savings?
    I’ll give you one guess…

  • Posted by Michael

    My favorite statement that’s been going around for the last year and a half is “Nobody could have predicted the collapse of the housing market.” This is pathetic. Somewhere down the road we’ll be hearing “Nobody could have predicted the collapse of the market for Treasuries.”

  • Posted by jane says

    Where does the money go after treasuries collapse?

  • Posted by mitchell porter

    “Where does the money go after treasuries collapse?”

    Out of anything USD-denominated, perhaps?

    To my naive way of thinking, after subprime the money fled into commodities, after signs of global recession it fled into cash and Treasuries, and I figure those are the last port of call before you exit the dollar entirely. So I’m thinking current dollar strength is just a bubble too, and at some point (perhaps when a $1trn US federal deficit looks unfundable) there will be that rush for the exits, into precious metals and other currencies.

    But don’t listen to me, I’m just a shoeshine boy.

  • Posted by DavidHK

    One correction to a previous post: Citic Pacific in Hong Kong suffered $2 billion loss for a bet against the rise of Australian dollar, not RMB.

    Brad’s thoughtful article has stimulated much interesting discussions. However, everyone seems to be focused on China, while other Asian countries are hardly mentioned. Japan, Korea, Taiwan, Singapore, …, are also big buyers of US treasury.

    According to news report today, Japan’s trade surplus is less than 1 billion $ in September 08, a whopping 94% decrease compared to September 07. Does it imply that going forward Japan can not buy as much treasury as before?

    Korea is in hot water now, with a plunging stock market and a run on Korean won. Seems that Korea would be on the market selling treasury to shore up its financial system.

    Taiwan, Hong Kong, and Singapore have all seen significant slow-downs. They are thinking about fiscal stimulus too.

    What would be the effects on BW2 by these other Asian countries?

  • Posted by bsetser

    David HK — most of these countries (japan aside) have been net $ sellers as they try to defend their currencies. and the dynamics of demand destruction in the US and Europe work against ongoing surplus in some countries as well — in september at least, the slump in Japan’s exports seems to have offset any fall in commodity prices (that may change over time — not sure how long the lags are in say japan’s oil bill — but the basic dynamic is a race between falling exports and falling commodity imports).

    to me a key question is what happens once we find a floor with some key asian currencies. does Korea then try to defend a depreciated won on the grounds that a) they need more reserves b) won strength hurts in a slowing global economy and c) the whole experiment of offsetting won strength with external borrowing/ domestic credit didn’t work out so well? And isn’t asian depreciation against the dollar eventually a recipe for more conflict over trade policy, especially as won weakness could be a brake on china’s political willingness to allow the rmb to appreciate v the $ (it clearly has appreciated on a broad basis b/c of the $’s recent move … )

  • Posted by ReformerRay

    October 22nd, 2008 at 4:07 am
    jboss Says:

    “Balanced trade” between absurdly rich and absurdly poor countries is a joke.
    Have you ever been to China or India?

    We are talking about 40% of the world population, including a lot of really smart people.
    If these countries will one day represent 40% of global GDP, it’s only fair.

    “Balanced trade” is just a chiffre for romantizising poverty (”They are poor, but they are happy.”) or even worse, belief in Western superiority.
    Both countries will grow a competitive industrial core with time. During that growth phase “unbalanced trade” helps them a lot. Once they reach developed status things will change.

    Wrong. All I want is balanced trade with the world – not just poor countries. Germany has acheived a trade surplus with the world. No reason the U.
    S. cannot have equal trade.

  • Posted by ReformerRay

    If balanced or equal trade exists between a poor and a rich country, trade will make the poor country grow faster (trade will be a larger share of poor country GDP).

    Equal trade does not penalize a poor country. It protects a rich country. The poor country will grow. No reason for the poor country to force the rich country to cease to grow in order to let the poor country grow much faster than can be achieved with equal trade.

  • Posted by ReformerRay

    The decline of U.S. economy and credit (in a relative sense) will move the U.S. toward equal trade BUT – when and if the U.S. recovers its footing, the trade deficit will again reappear, as it did after 1991.

  • Posted by ReformerRay

    The philosophical and theoretical justification for equal trade is a long story but it must be spelled out before the free trade ideology can be rooted out. Much work to do to convert the U.S. to equal trade as an ideal – not just an accident.

  • Posted by ReformerRay

    I will disappear for a day. But I would like to read disagreements.

  • Posted by RebelEconomist

    Reformer Ray,

    Trade is balanced, by definition, when financial assets are included. It is just that the imbalance in, say oil, matches the imbalance in intertemporal preference (not necessarily to do with being rich or poor by the way). Why insist on balancing the capital account part of the balance of payments when you don’t expect a balance in oil?

  • Posted by ReformerRay

    The outflow of financial assets is the problem. Trade without the outflow of financial assets would be wonderful. However, imports must be paid for with dollars. When the imports are not matched by exports, the dollars sent overseas become permanent claims on financial assets produced in the U.S.

    The U.S. firms being purchased by foreign countries is due to the Negative Net International Investment Position of the U.S.

  • Posted by ReformerRay

    I found it interesting how so many commentators were pleased to point out how the uptick in exports has helped the U.S. economy. These same folks ignore the fact that more imports than exports harm the U.S. economy.

  • Posted by ReformerRay

    “intermporal preferences” refer to what we choose – not what our children would prefer. I dislike the term. Better say “forcing our children to live with less financial resources in the U.S.” because we prefer to consume more than we produce.

  • Posted by RolfeWinkler

    Great post Brad. What a rebuttal to the folks who say the Chinese have no choice but to keep financing our deficits. It seems that you’re arguing they have no choice but to stop….

  • Posted by RebelEconomist

    Reformer Ray,

    The US has FDI all over the world which represents a permanent claim on the production of those countries. Why should the US be any different?

    Intergenerational preferences are an internal matter. Actually though, I missed part of the story. The part I neglected was intertemporal production opportunities. If the present generation borrow to finance highly productive infrastructure – eg railways – the net result for future generations will be positive. The deficits, which amount to borrowing from overseas, do not have to burden future generations if something useful is done with the resources. That is where the internal intertemporal choice is made.

  • Posted by ReformerRay

    Rebel economist -

    The Net International Investment Position says that more foreigners own U.S. assets than the other way around. It is the negative balance that is the problem, not the existence of FDI.

    The present generation did not borrow to finance highly productive infrastructure. The present generation borrowed to pay for consumer goods, most of which have been eaten or discarded. We do possess more durable goods, such as houses and cars, but we would have been better off with a less debt driven accumulation production cycle.

    No way the large trade deficit of the past decades can be rationalized as good for the U.S.

  • Posted by RebelEconomist

    Nowadays, the US has a negative balance, but in the past the US was happy to have a positive balance. Now the boot is on the other foot.

    I agree that the resources borrowed have been squandered, but that cannot be blamed on the lender, or even the existence of lending.

    Basically, the US screwed up. It is time they stopped blaming everyone else and started an honest attempt to get back on track.

    The same applies to the UK.

  • Posted by ReformerRay

    Michael says:

    Just as the apologists for the crazy over-leveraged risk-taking by banks (and others)used the fact that the profits were obviously fabulous and the borrowers just kept coming as “proof” of the sustainability of the process, the apologists for massive Treasury printing to aid zombie banks and evade deflation use the fact that Treasury prices are fabulous and the lenders just keep coming as “proof” of the sustainability of the process.

    When you hear the question asked, “Where will the next bubble be?” you already should know the answer, because it’s right in front of you. Treasuries as an asset are in a price bubble comparable to stocks, housing, and commodities in their turn. The arguments for why it makes (short-term) sense for capital to flow into the Treasury bubble are no different than the arguments for why it made sense (at the time) for capital to flow into the the other assets during their bubble times; and the ending will be the same.

    Shorter-term thinking, whether driven by greed or fear, produces the same result: a longer-term outcome you really don’t want. Not only is the banking crisis consistent with an eventual unwind (slow or crash-speed) of the balance of financial terror, it will eventually lead directly to it.

    October 22nd, 2008 at 9:00 pm

    (above reproduced from post by Michael).

    This makes sense to me, except for a doubt caused by his phrase “whether driven by fear or greed”. Short term thinking driven by greed did produce our problem. But short term thinking driven by fear may produce some good results. Debt will be reduced. Short term thinking driven by fear is sustaining the low interest paid by the Treasury. Perhaps fear and short term thinking will continue to sustain the low interest on Treasuries longer, much longer, than a long term perspective would require.

    If we have 3 years of sustained fear and low interest treasuries, maybe we will be able to reduce debt to a level that the economy can begin to function in a more “normal” fashion.

  • Posted by ReformerRay

    Rebel economists says:

    Basically, the US screwed up. It is time they stopped blaming everyone else and started an honest attempt to get back on track.

    The same applies to the UK.

    Agreed. What we are discussing is how to get back on track.

    I maintain the ideology of free trade is a barrier and a handicap to getting back on track.

    Equal trade is the only ideal for international trade which insures that every participating country will benefit from engaging in trade (because equal trade requires each country to export – and exports require domestic production – and domestic production increases GDP).

    A rich, consumer oriented country will not achieve equal trade without barriers to entry of imports. The best way to reduce imports (not eliminate them) is a tariff on ALL imported goods produced in the five countries that account for 60% of the U.S. trade deficit in 2005 and 2006.

  • Posted by ReformerRay

    The UK and every other country with a significant trade deficit should adopt the policy advocated above for the U.S.

  • Posted by don

    I favor market solutions to the trade balance. If people in some countries want to borrow at existing rates whereas others want to lend, let them decide on the lending flows (and consequent trade imbalances). However, i object to currency mercantilism in all of its forms, whether explicit (Chinese currency interventions) or implicit (the notion that Japanese authorities would not let the yen rise dramatically, which encouraged over rambuctious yen carry trades).

  • Posted by ReformerRay

    don -

    We need to talk.

    I am unwilling to accept most of what is commonly assumed. For example, trade imbalances are created by people buying and selling goods and services. The lending flows are a separate issue. Money is shipped from one country to another for a variety of reasons. One reason is to pay for imports. In that case, causation flows from purchases to money flows.

    Savings = investment + the trade balance. I have good reasons for assuming that the level of savings is controlled by the level of the other two variables.

    Our trade balance is produced by market forces. The unbalanced result of the last 3 decades cannot be reversed by market forces.

    Currency mercantilism is chosen by the Japanese and the Chinese because they are sovereign nations. The only choice the U.
    S. has is to adjust our behavior if we do not like the results of their choices. It is irrelevant to the authlorities in those nations what some outsiders think. They are clear about what is good for their nations.

  • Posted by bena gyerek

    i think it makes a lot of sense for china to diversify its reserves out of dollars into other currencies in the next few weeks.
    – china clearly now regrets having put all its eggs in one basket. as noted elsewhere (a) its dollar investment is effectively illiquid by virtue of its sheer size, (b) the fed abused its support of the dollar by keeping rates low for so long, (c) it already experienced the fx losses and loss of export competitiveness in europe (a bigger market than the usa) that resulted from dollar devaluation.
    – timing is excellent. the current dollar rally is highly technical in nature (forced unwind of fx carry trades, general impossibility of rolling existing dollar borrowing, hedge funds prefunding dollar redemptions, everyone having to meet dollar cash margin calls). the looming collapse in demand by indebted us households (a problem that is largely unique to the usa and uk) means that the dollar will have to fall in the medium term against other currencies. the us economy is a very unattractive investment, no matter how much warren buffet talks up his book.
    – china can cut deals with the countries whose currencies it supports – access to european export markets, access to australian or brazilian commodities, etc
    – china has an interest in maintaining the stability of the global financial system, which is now threatened by a global emerging market currency crisis leading to another round of massive g7 bank insolvencies. china would also gain a lot of kudos if it was seen to be riding to the rescue of these countries.

    would be interested to know your thoughts..

  • Posted by Michael

    BW2 may be dying, but the Treasury and Fed are basing their policies and practices on the assumption that it will continue forever; similarly, the White House and Congress are basing their policies and practices (rhetoric aside) on the assumption that Federal debt does not have to be repaid, and in fact can increase indefinitely. This reminds one of the assumptions that underlay the policies and practices of the financial industry over the last ten years. The implications of BW2 and/or the Permanent Debt paradigms completely disintegrating (like the Cheap Credit/Maximum Leverage paradigms have done) should make these the top priorities of the U.S. Government. Instead, we may be hearing (again) down the road “No one could have predicted this would happen.”

  • Posted by Mortgage Broker London

    What about the implications of a more sustainable future? Surely this would unbalance the system even more. Those in charge of trade and the economy will have to find a new money making game to play.

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