Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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Yes Virginia, there was an international financial crisis in 2007 and 2008

by Brad Setser
June 23, 2009

Now that the markets have lost a bit of their froth, it seems fitting to note just how sharply trade — and private financial flows — have contracted over the past year. The US q1 balance of payments data is rather stunning.


Trade (as we all know) contracted far more rapidly during this cycle than in the past.

But the fall in private financial flows — outflows as well as inflows — has been even sharper than the fall in trade flows. US private investment in the rest of the world rebounded a bit in the first quarter, but private demand for US financial assets remained in the doldrums. Private investors were still pulling funds out of the US in the first quarter.

A close examination of the graph indicates that demand for US financial assets by private investors abroad actually peaked in the second quarter of 2007 — a peak that came after gross private flows (inflows as well as outflows) rose strongly in 2005 and 2006. That surge was — in my view — linked to the chain of risk associated with a world where central banks took the currency risk associated with financing the US external deficit and private intermediaries took the credit risk associated with financing ever more indebted US households.

Any interpretation of what caused the crisis has to explain this surge. But any interpretation of the crisis also needs to explain why US imports and exports continued to rise — and the US trade and current account deficit remained large — even after private inflows collapsed.

I suspect that part of the answer is that a lot of private inflows were linked to private outflows — as special investment vehicles operating in say the US could only buy long-term US mortgage bonds if someone in the US bought their short-term paper. The fact that private outflows collapsed along with private inflows meant that net private flows didn’t fall at the same rate. Indeed, at times – notably in q4 2008 — the fact that US investors pulled funds out of the rest of the world faster than foreign investors pulled funds out of the US provided the US with a significant amount of net financing.

And part of the answer is that private investors never were the only source of financing for the US current account deficit. Strong central bank demand — especially in late 2007 and early 2008 — offset a fall in private flows.

One thing though is sure: the scale of the collapse in private financial flows during this crisis is entirely unprecedented. There were a few instances in the past when private flows (excluding flows into Treasuries) were slightly negative. But outflows of 5% of GDP in a quarter are entirely unprecedented. And now that the US data has been revised to reflect the survey, adding private purchases of Treasuries back in doesn’t change all that much …

Net private demand for long-term US financial assets – that is purchases of US securities and foreign direct investment in the US, net of US purchases of foreign securities and US direct investment abroad — has been weak for some time now.


There is more to say on the details of the balance of payments data, but I’ll live it for another post.


  • Posted by D Gross

    Very interesting charts (again).

    A couple of quick observations/questions

    Doesn’t the capital flow chart from 2000 onward look like an amplified version of the chart from 1995-2000? This seems to be what US bubbles look like.

    Are you sure that % of GDP is the right measure? Global capital flows have been growing much faster than GDP for decades as the world becomes more interconnected (and leveraged) and capital controls come down. Hence, I would expect any pro-cyclical changes in capital flows to look a lot bigger now as a % of GDP than back in the 70s, 80s or even 90s. Would also be interesting to see the changes as a % of capital stock.

    As you point out, international finance has gotten more complex, with hedge funds and US-controlled SIVs and trusts in the Caymans and London, so it is hard to nail down exactly who is a foreign and who is a domestic investor.

    In any case the mid-2007 peak on your charts was well timed with the start of the mortgage crisis Many London/Cayman-based hedge funds blew up and liquidated portfolios (including Bear and UBS). At that same time, the Fed and the ECB started taking dodgy collateral directly from investment banks in order to finance their holdings. Public funding replaced private funding in the repo markets.

    The economy didn’t start slowing immediately because the consumer did not appear to be affected by these early collapses (though foreclosures were already picking up). The drop in US consumption seemed to occur only after Lehman failed and a more widespread crisis in confidence crushed the stock markets.

    We seem to have gotten over much of that crisis in confidence, but as your charts indicate, cross-border capital flows are far from normal, central banks still run the repo markets and few private investors are buying mortgages. I wonder if the return in confidence we have seen this quarter in 2009 (stocks up, EM up, commodities up) is as misplaced as consumer confidence was in 2007?

    I can see hundreds of small to mid-sized US banks going down over the next year due to commercial real estate troubles, and we could see some US municipal defaults as well. The US Federal government will step into the breach with more bailouts but the patience on the part of US taxpayers and foreign investors for bailout upon bailout coincident with huge healthcare, energy and stimulus spending initiatives may be limited. The US is far from “out of the woods”, as your charts show.

  • Posted by DJC

    The US government is set to provoke a new international crisis with a trade War targeting China. Will the China PBoC still be purchasing hundreds of billions of US Treasury bonds?

    U.S. Trade Representative Ron Kirk is expected to launch a WTO case against China on Tuesday when he holds what his office called a major news conference regarding U.S.-China trade.

    “If the U.S. does indeed file a WTO case against China on raw material export restrictions, we welcome this action,” said Tom Gibson, president of the American Iron and Steel Institute.

    “U.S. and NAFTA steel producers have long believed that this government of China policy is a WTO violation and that it is benefiting Chinese manufacturers artificially while disadvantaging manufacturers everywhere else,” he said.

  • Posted by DJC

    Lessons Of The Great Depression Forgotten

    Boomers close to retirement are now (finally) scared to death as the equity in their houses has been vaporized. School age children are seeing homes foreclosed, and families destroyed over debt. The American consumer, who nearly everyone thinks will be back as soon as the economy picks up are mistaken.

    Secular shifts like these come once in a lifetime. Sadly it’s too late for many cash strapped boomers counting on equity in their houses for retirement.

    The lessons of their great grandfathers who lived in the great depression era were forgotten. Over time, everyone learned to ignore the dangers of debt, risk, and leverage. Belief in the Fed and the government to bail out any problem are ingrained. Bank failures are distant memories.

    Anyone and everyone who wanted credit got it, and on the easiest of terms: subprime, pay option arms, reckless leverage, and covenant lite debt and toggle bonds that allowed debt to be paid back with more debt. That’s what it takes to hit a peak.

    Peak Credit

    Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.

    It took nearly 80 years for people to get as reckless as they did in 1929. 80 years! Few are still alive that went through the great depression. No one listened to them. That is the nature of the game. The odds of a significant bout of inflation now are about the same as they were in 1929. Next to none.

    Children whose families are being destroyed by debt now, will keep those memories for a long time.

  • Posted by beezer

    Re: DJC and the WTO press conference.

    We’re finally admitting we’ve been getting our collective clocks cleaned by a focused, mercantilist country. And not just China.

    Trade should be a win/win situation.

  • Posted by Glen M

    I hope the WTO action also addresses quotas along with tarriffs.

  • Posted by bsetser

    On topic comments please; this was primarily a post about financial flows — not trade.

  • Posted by Cedric Regula

    I think it’s important to remember we had a collapse in financial flows, of the private investment variety, and of the CB recycling variety. But in addition to that we had a credit crunch too.

    The timing of these things varied.It’s probably handy to look at a chart of Libor over these time frames, along with the BOP data to get a sense of the whole picture, and realize we had private investment, CBs and short term banking credit all exerting influence on the real economy.

    But it ain’t over. Banking isn’t out of the woods yet. Lots of residential variable rate mortgages reset again in the next year or two. Commercial property, credit card and other consumer debt is the next shoe to drop.

    Talk of Green Shoots has just about disappeared on CNBC and it has been replaced with more serious talk, like was the stock and commodity rally justified by reality or not.

    Treasuries are even looking firmer as weak economy concerns may even be outweighing supply concerns. At least for the last two weeks anyway. There is talk that the Dollar might be better than commodities again. So a strong dollar-treasury cycle may be brewing, as unlikely as that seems.

  • Posted by --Andrew

    Dr. Setser, this may be a simplistic question, but typically how tightly are the balance of payment flows tied to/intermixed with trade export/import numbers (which have also been tanking as you have previously detailed)? I’m curious about how much of this is pure demand for U.S. financial products versus simply the cash component of an underlying import/export transaction which then gets repatriated or locally invested by the importer/exporter ( or by proxy by a Central Bank).

    To me, tanking of pure financial product demand could be seen as a loss of faith in U.S. markets or future U.S. economic outlook. Tanking of a highly trade dependent flow, could just be that, a reflection of the current crash in international trade flows. Would this view be wrong?

  • Posted by Rien Huizer

    Looks like the volatility of NET flows in the 70s and 80s was at least as great as now. Perhaps the practive of leveraged investing is making the statistics very difficult to interpret.

  • Posted by guest

    The privilege of jesuites is about answering a question with a question.
    Where those capital inflows came from and through which conduits?

  • Posted by DJC.

    With private capital exiting the US Economy, shouldn’t the US Foreign policy elites drop their hostile and antagonistic line towards the Chinese. In order to keep China investing in US Treasuries to finance record budget deficits, it might be helpful not to criticize your creditor. If the Washington Consensus elites are really concerned about foreign capital dependence, than the United States needs to abandon its expensive global supercop presence across East Asia and the Middle East. At this juncture in history, the US cannot possibly economically or militarily “contain China from becoming the largest economic superpower in the world”.

  • Posted by bsetser

    rien — there was a lot of volatility in net private (and net official flows) in the 70s. gross flows were more volatile recently — but the linked fall in outflows and inflows limited the volatility in net flows. the partial answer to guest’s question is that a lot of the flows were tied to the expansion of the shadow financial system in the uk. when conduits blew up, so did gross flows -as lots of vehicles (and european banks) funded their purchases of long-term us securities by selling s-term paper. the rise of london as an offshore center for the us (not just an offshore center for global dollar deposits from ems and petrostates) contributed to the expansion of gross flows.

    andrew — it varies. two way flows linked to the creation of an offshore intermediary aren’;t that linked to trade flows. a us banks that sets up a vehicle to borrow from us money market funds and buy l-term us debt isn’t generating any net inflow. the same business could have been done on shore and on balance sheet. but to the extent this was part of the chain of risk taking that allowed us households to borrow more than they earned, it indirectly still supported the us household and thus the us external deficit. it all goes back to some of the concepts in the brender and pisani paper.

  • Posted by FollowTheMoney

    We’re in line for both imports and exports to contract below the 5% level as the consumer continues to tighten the belt. The question is will china be hurt more than the u.s. as exports deteriorate? My guess is yes, my thoughts is many people are too optimistic on the 2009 internal domestic demand structure in China…

    @ DJC

    it’s truly not in China nor U.S. interest to engage in economic warfare. I don’t know about everyone on this board, but i’d rather go for non-polarity rather than a “new superpower” aka China…Although we in the United States have lived beyond our means, the majority of the people in this nation are good people. that’s my 2 cents.

  • Posted by bsetser

    barring a depression, imports and export should stabilize before they get to 5% of GDP (a cumulative fall of about 60-70% … ouch). green shoots got overplayed, but the “free fall” of q4 and q1 did end in q2. Things didn’t get worse at the same pace — even if they still haven’t gotten a lot better.

  • Posted by Cedric Regula

    2 year auction results are in.

    $40B of 2 yearlings sold like hot cakes, actually strengthening in price. 68%were “indirect bid”, the CB plus biggy category.

    Rates fell big at the long end. It’s either deflation or the carry trade.

    Fed meeting the next couple days and the ECB sells a bunch of bonds tomorrow. Macro Man covering that one.

    Only anomaly is the buck dropped big today. Both against major and minor categories. Only thing that comes to mind is they fear “event risk” of what Bernanke may tell us.(clue: it’s NOT a rate hike.)

  • Posted by Ying

    So the negative sentiment dominates the market again and the stock market will start another round of stumbling downward? Commodity price will move in the direction depending on the decisions of China? I am wondering who is trading in S&P stock market right now.

  • Posted by DOR

    When considering the two-way benefits of trade, it is far too common to simply ignore the benefits to the consumer.

    Increase the cost of living by the difference between imported products and domestic ones, and see what kind of standard of living arises.

  • Posted by Hal

    Why don’t you use graphs that expand in size when one clicks on them? As they are, they are difficult to read.

  • Posted by London Mortgages

    I think that the cycle needs to be looked out over a longer period. Natural flux and variation are closely linked with confidence, and this is apparently shifting gradually from the west to the east.