Barry Eichengreen writes exceptionally well:

“THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.

We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over.”

What went wrong? Eichengreen argues that those who wanted to take big financial risks were biased toward theories that supporting taking big financial risks.

“the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking”

That seems generally right.

Especially as those who tend to be better at seeing risks than opportunities tend to warn of trouble well before it breaks out, and even if they identify certain underlying vulnerabilities, are unlikely to call every move in the market.

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There is a very widespread sense that the US “needs” China more now because it is issuing more Treasuries to finance its fiscal deficit.

That isn’t quite true. As a result of the crisis, the US consumer has started to save and American businesses have reduced their investment, so the US “needs” to borrow a lot less from the rest of the world. The US needs to borrow from the world when private Americans do not want to save and the US running a large trade deficit, not when private Americans want to save and the trade deficit is down.

The US government is borrowing more, from almost everyone. But other sectors of the economy are borrowing a lot less.

Of course, China bilateral surplus with the US remains, as does its global surplus — so China is a bit of an exception to that general story. China’s surplus is likely the main counterpart globally to the United States remaining external deficit.

But it is only a partial exception. Setting aside shifts in the composition of China’s reserves (selling Agencies for example), the number of Treasuries purchased by China’s government is driven more by China’s reserve growth than by the amount of Treasuries the US issues.

Now a fiscal deficit that leads to a surge in demand that pushes up both the US trade deficit and China’s surplus could push up Chinese demand for Treasuries. So there is a potential conceptual link between the number of Treasuries issued to finance the fiscal deficit and China’s purchases of Treasuries. Over the last few months, though, the trade deficit has fallen sharply even as Treasury issuance as soared. The bigger fiscal deficit leads to more demand for the world’s goods and a bigger external deficit story may prove true over time, but it isn’t an accurate account of the current dynamics.

Arpana Pandey and Paul Swartz have plotted our (our = Center for Geoeconomic Studies) estimates of the Treasury purchases of the various BRIC countries relative to the net issuance of marketable US Treasuries over the last 12ms of data. By net, we mean Treasuries not held by the Fed. That means if the Fed sells a lot of its Treasury holdings, we count it as an increase in stock of Treasuries in the market. And conversely if Fed buys Treasuries, that would reduce the stock of Treasuries in the market.

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That isn’t a question that is usually asked in the debate about the “right” size of the IMF. But it strikes me as a question worth asking.

Back in 2006, US growth slowed relative to growth in the world. Private demand for US assets fell.* But the US didn’t have to “adjust” — that is to say bring its trade deficit down to reflect the reduced availability of private financing. Why not? Emerging economies, who received most of the influx of private money not going to the US, generally used this influx to build up their reserves. A rise in financing from central banks and sovereign funds offset the fall in (net) private demand for US assets.** The US trade deficit fell a bit relative to US GDP, but not by all that much.

Thanks to a generous supply of credit from the emerging world’s central banks, the party kept going long after private investors ceased to be willing to finance it.

Suffice to say that when emerging economies running comparable deficits to the US encounter a comparable fall off in private financial flows, the amount of financing that gets recycled back their way by the US and EU (through institutions like the IMF) is far smaller. Between 1997 and 1999, “volatile” private capital flows (bank loans and portfolio flows, I left FDI out) swung from a $100 billion inflow to a $100 billion outflow. The net increase in IMF’s lending over this time by contrast was only around $30b — not all that much relative to the $200 billion swing.

The current crisis isn’t all that different. Between 2007 and 2009, volatile capital flows are expected to fall from a positive $250 billion to a negative $400 billion — a swing over over $650 billion. IMF lending — based on all existing programs — will increase by close to $120 billion (see this chart by my colleague Paul Swartz). That is more than in the past, but not enough to offset the fall in capital flows, and certainly not enough to offset the combined impact of lower capital flows and lower commodity prices on the commodity exporting region.

Scaled to world GDP, the current swing in private capital flows and the (projected) rise in official lending looks roughly similar to the swing back in 97-98.

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This week’s Economist covers two topics that regular readers know very, very well: China’s reserve growth and China’s holdings of US debt.

The estimates for China’s US holdings in the Economist are based on the methodology laid out in a paper that Arpana Pandey and I did in January. But that paper was written before the Treasury released the results of its June 2008 survey of foreign portfolio investment and consequently the estimates in the actual paper are now a bit out of date. The last survey showed fewer Treasury purchases than we expected, and more equity purchases. * The estimates in this week’s Economist reflect the results of the last survey, and therefore differ from the estimates in the underlying paper. We should have an updated paper out soon as well.

The most recent US survey of foreign portfolio investment also showed somewhat smaller Chinese purchases of US assets from mid-2007 to mid-2008 than I would have expected — something I plan to discuss in more detail. That could be evidence of (modest) diversification away from the dollar from mid-2007 to mid-2008, but it equally could represent greater use of private fund managers. If China handed some of its reserves over to a private manager, the US survey data wouldn’t attribute those funds to China. The increase in China’s Treasury holdings last fall was far larger than can be explained by the underlying growth in China’s reserves — and one explanation for the strong recorded inflows would be that China was pulling funds out of privately managed accounts. Tracking China’s portfolio is an art not a science.**

The Economist closes with a key point: the main constraint on China’s reserve management is China’s own policy of managing its currency against the dollar.

China is trying to have it both ways. It wants to lessen its dollar exposure, but it also wants to hold down the yuan. The picture has been temporarily clouded by shifts in “hot capital” flows, but so long as China runs a large current-account surplus, its reserves will rise. In order to keep the yuan weak against the dollar, a large chunk of those reserves will end up in greenbacks. Beijing’s appetite may not match Washington’s growing need for cash. But China cannot sour on the dollar without letting its own currency rise.

China’s reserve growth has been temporarily held down by speculative outflows, but there are (tentative) signs those outflows have slowed — which implies that China’s reserves are likely to resume their steady upward march so long as China maintains a large current account surplus.

And that isn’t necessarily a good thing. Any abrupt change, of course, would be bad. The past several months have illustrated why gradual transitions that allow needed economic adjustments to take place over time rather than all at once are important. But I personally don’t think it is in China’s interest to continue to invest so much of its savings in US assets, especially on terms that imply likely losses for China’s taxpayers. And I equally don’t think it is in the interest of the United States to rely so heavily on a single country’s government for financing. A smaller US current account deficit, financed by a more diverse group of creditors, would be far healthier.

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Or perhaps a Sino-North Atlantic or Sino-Euramerican imbalance. Europe plays a supporting role in the drama.

If oil averages $50 or so this year and $60 or so next year – and if intra-European surpluses and deficits are netted out – the world’s macroeconomic imbalances reduce to the United States external deficit (which the IMF estimates will be under 3% of US GDP in 09), a somewhat smaller EU deficit and China’s 10% of GDP surplus.

On the surplus side of the global ledger, the IMF forecasts that there will soon be China – and almost no one else.

Stacking Europe on top of the US makes it hard to see Europe’s contribution to offsetting Asia’s surplus over the past two years. The US deficit peaked in 06; if Europe’s deficit hadn’t increased dramatically since then, Asia couldn’t have run such a large surplus (remember that from 06 on, most Asian currencies were deeply undervalued v Europe) at the same time as the oil exporters. Deficits and surpluses have to add up globally.

The IMF doesn’t current expect China’s stimulus to bring China’s current account surplus down. From a savings and investment view, I suspect the IMF expects a rise in public investment to offset a fall in private investment, not increase total investment – and the swing in the fiscal deficit to partially be offset by a rise in household savings. Just a guess though. And on the trade side, the fall in exports will be offset by the impact of lower commodity prices. The fact that China’s current account surplus is expected to stay large over time also suggests that the IMF continues to believe that the RMB is undervalued.

The bigger question though is whether or not China will still be willing to accumulate the very large claims on the world implied by the IMF’s forecast. China is already worried about the long-term value of its $2.3 trillion or so in reserves and hidden reserves.

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One issue to watch over the next few days, as the world’s finance ministers gather for the IMF’s spring meetings: whether or not the G-20 (and other) countries carry through on their pledge to expand the resources available to the IMF.

The IMF cannot supply credit to a host of troubled emerging markets unless it gets credit (via its supplementary credit line, or a bond issue sold to key central banks with excess reserves) from a bunch of countries in a (somewhat) stronger financial position.

But also give the IMF credit for producing analysis that has become an essential guide to the current crisis. Like Dr. Krugman, I am eagerly awaiting the release of first few chapters of the WEO tomorrow. That is something that I couldn’t have credibly said all that often in the past. The detailed WEO will provide a baseline, among other things, for assessing whether the fall in the world’s macroeconomic imbalances in the first quarter can be expected to persist for this year, and for the next.

The IMF’s Global Financial Stability Report – released today – already provides a baseline for assessing the scale of the losses that the last credit cycle will generate (gulp, over $4 trillion, with $2.8 trillion from the US – two times as much as the IMF forecast in October) and thus, in broad terms, the scale of the new capital the financial sector needs.

This crisis challenged the IMF. A truly global crisis calls out for a global response, underpinned by high-quality global analysis. A few years back, the IMF’s surveillance wasn’t perhaps as focused on the underlying risks of an unbalanced and highly leveraged world as it should have been. Just look at the IMF’s 2007 economic health check for the US , which declared – a minus a caveat or two – that the core of the US financial sector was well capitalized and “relatively protected from credit risk” (see paragraph 5, on p 10 of the staff report/ and paragraph 5 of the PIN/ ). Oops.

Of course, the IMF’s assessment of the US financial sector echoed the conventional wisdom of the time. And, in other areas, the IMF can credibly argue that it highlighted risks that others wanted to ignore. It, for example, consistently called attention to the build-up of balance sheet risk in emerging Europe.

Suffice to say that the IMF didn’t risk making the same mistake in its current Global Financial Stability Report. Chapter 1 of the Global Financial Stability Report makes for sobering reading.

The IMF paints a picture of a global economy where neither large financial institutions in the world’s economic and financial core nor those emerging market governments with large external financing needs can count on financing themselves in private markets. Both sets of borrowers, in effect, now rely on the support of official institutions, whether the IMF, the the world’s large central banks or taxpayers. The financial sector relies on official support for the money it can no longer raise in the “wholesale” funding market*, and emerging markets to offset the withdrawal of cross-border bank lending.

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Central bank purchases of Agencies in 2007 (Setser and Pandey estimate, based on the survey data – the BoP data should be similar once it is revised to reflect the 2008 survey): $300 billion.

Central bank sales of Agencies in 2008: close to $100 billion.

That is a one-year swing was close to $400 billion.

It just occurred to me that this was a larger swing – in dollar terms – than the swing in non-FDI private capital flows in Asia in 1997 and 1998. According to the IMF’s WEO database, developing Asia attracted $70 billion in portfolio and bank inflows in 1996. In 1998, $110 billion flowed out, for a total swing of around $200 billion.*

So much for the notion that sovereign investors are always a stabilizing force in the market.

Maybe sovereign funds are different (as the FT argues), but central banks ultimately proved to be rather loss adverse. They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in. Kind of like fickle private investors …

Of course, the comparison between central banks now and private investors in Asia is a bit unfair. Developing Asia back in the 1990s had a GDP of about $2 trillion. The US today has a GDP of around $14 trillion. So the swing in demand for Agencies is far smaller, relative to US GDP, than the swing in private capital flows was relative to Asia’s GDP. The swing in capital flows to Asia was in the realm of 8% of its GDP. Even if the fall in Agencies in 2009 is around $150 billion (it was $125b in the 12ms through February, but the basis for the y/y comparison will start to shift as the year goes on … ), the swing for the US will be more like 3% of US GDP.

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Economists scouring the globe for highs of hope (or at least a slower rate of decline) have found a few green shoots in China. A smaller fall in the March import data. A faster y/y rise in industrial production in March than in February. Signs of life in the housing market. The (undeniably) large increase in bank lending.

I would feel a bit more comfortable, though, if China’s trade data wasn’t tracking the US trade quite so closely. China exports a bit more than the US and imports a bit less, but they are basically comparable in size. And, well, the y/y change in a rolling 3m sum of China’s exports doesn’t look much different that the y/y change in US exports; and the y/y change in China’s imports doesn’t look much different than the y/y change in US imports.

The green shoot from the March import data shows up in the chart – the pace of the y/y decline in China’s imports slowed in March. But the overall story from the trade data is still quite grim. Making judgments on the basis of a single indicator — especially a nominal indicator influenced by price swings – is always risky. But the trade data doesn’t suggest that China’s economy is in robust health.

The simplest explanation for the tight correlation between US and Chinese imports would be a fairly synchronized downturn in both the US and China. That would explain why both countries are importing substantially less – and both are experiencing larger falls in their imports than can be explained by the fall in commodity prices.

Other explanations are obviously possible: About ½ of China’s imports are for re-export, so a large share of the fall in China’s imports is a reflection of the fall in China’s exports. And China may import more commodities than the US, and thus falling commodity prices (though there are limits here: the US imports a higher share of its oil than China does) may have a bigger impact on the data.

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Chinese reserve growth has slowed. Russia’s reserves are down in the first quarter (though most of the fall was in January). Saudi foreign assets fell in January and February.

Most emerging economies — including some that thought they had ample reserves a year ago — want more foreign currency liquidity. They are looking to borrow foreign exchange pretty much any place they can. Russia, Korea and Abu Dhabi are all poised to issue international sovereign bonds. Other cash-constrained countries (and companies) are turning to China for help, especially if they have a bit of oil or iron ore to offer in exchange. Still others are turning to the IMF.

The amazing thing is that central banks are buying more Treasuries now, when their reserves are shrinking, than they ever did when their reserves were growing.

After several years when plain vanilla Treasuries were out of favor as a reserve asset, demand for Treasuries surged late last year. It fell off a bit in January, but picked up again in February. Moreover, we know that little has changed since then. The Fed’s custodial of Treasuries are up by a stunning $76 billion since the end of February. Central banks were particularly active in the past week. Custodial holdings of Agencies are down by a little more than $8 billion since February.

Foreign demand for Agencies has truly disappeared. Look at the following chart, which shows rolling 12m purchases of all Treasuries and Agencies, includes short-term T-bills and short-term Agencies:

Indeed, the fall off in demand for long-term Agencies has been sharper than the fall off in demand for long-term US corporate bonds or equities.

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This wasn’t exactly a surprise, despite Secretary Geithner’s comments in January. The US made a large global stimulus — and a larger IMF — its priority in the G20, not exchange rate reform.

Moreover, this isn’t the right time to force resolution of this issue.

China’s exports to world and US imports from China are both falling. Chinese reserve growth — read the amount of dollars China has to buy to keep its currency from appreciating — has fallen sharply. And perhaps most importantly, the RMB was one of the few emerging market currencies that appreciated during the crisis in real terms.

According to the (recently rebased) BIS real effective exchange rate index, the RMB has appreciated by over 10% since June 2008 — and by almost 18% since December 2007. Other indexes show sligtly smaller real appreciation. But there is little doubt that China appreciated in real terms when many other emerging economies depreciated in real terms. This seems to have been been an important factor in the Administration’s decision. The Treasury noted that the RMB was basically stable when most other emerging currencies fell (“As the crisis intensified, the currency appreciated slightly against the dollar when most other emerging market and other currencies fell sharply against the dollar.”)*

Make no mistake, China’s currency still looks undervalued. It is only a bit higher — according to the BIS index– than it was in 2001 or 2002, back when China was exporting a fraction of what it does now. In other words, the rise in the productivity of China’s economy hasn’t been mirrored by a rise in the external purchasing power of its currency. That is a big reason why China’s current account surplus remains large.

And the underlying issue remains: the biggest driver of moves in China’s real exchange rate remains moves in the dollar. History suggests that China cannot count on dollar appreciation to bring about the real appreciation it and the global economy need if China’s surplus — and thus China’s accumulation of money-losing foreign assets — is going to come down. It will be hard — in my view — to have a stable international monetary system if the currencies of all the major economies but one float against each other. And China is now a major economy by any measure.

But it makes far more sense to have a fight over China’s exchange rate regime when China’s currency is depreciating in real terms and Chinese intervention in the foreign exchange market is rising — not when China’s currency is rising in real terms and Chinese intervention in the foreign exchange market is falling.

Especially when there are a few tentative signs that China’s stimulus may be gaining some traction.

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