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Brad Setser: Follow the Money

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The (almost) dollar crisis of 2007 …

by Brad Setser
July 30, 2009

It is now rather common to argue that those economists who anticipated the crisis anticipated the wrong crisis – a dollar crisis, not a banking crisis. Robin Harding of the FT writes:

“If economists try to predict crises they will get it wrong, and that will reduce their credibility when they try to warn of risks. It was in their warnings that economists failed: plenty talked of ‘global imbalances’ or ‘excessive credit growth’; few followed that through to the proximate sources of danger in the financial system, and then forcibly argued for something to be done about it.”

Free exchange made a similar point last week.

“It’s interesting that he [Krugman] mentions Nouriel Roubini, who is one of several international economists who famously saw some sort of crisis on the horizon but who very much erred in guessing the precipitating factor. I think international macroeconomists have been looking for a dollar crisis for quite some time, and they believed that such a crisis would bring on the meltdown. Instead, the meltdown occurred for other reasons and paradoxically reinforced the position of the dollar (and, for the moment, many of the structural imbalances that have troubled international economists).”

Actually, the crisis has — at least temporarily — reduced those structural imbalances. The US trade deficit is much smaller now than before. And, be honest, the criticism directed at Dr. Roubini should have been directed at me: after 2005, the locus of Nouriel’s concerns shifted to the housing market and the financial sector, while I continued to focus on the risks associated directly with the US external deficit. But it is hard to argue against the conclusion that the current crisis stems, fundamentally, from the collapse in the financial sector’s ability to intermediate the US household deficit – not a collapse in the rest of the world’s willingness to accumulate dollars. The chain of risk intermediation broke down in New York and London before it broke down in Beijing, Moscow or Riyadh.

At the same time, I also think the argument that warnings about “imbalances” (meaning the US trade deficit) were wrong neglects one important thing: there was something of a balance of payments crisis in 2007, although it took a very unusual form. When US growth slowed and global growth did not, private investors (limited) willingness to finance the US deficit disappeared. Consider the following graph, which plots (net) private demand for US long-term financial assets (it is based on the TIC data, but I have adjusted the TIC data for “hidden” official inflows that show up in the Treasury’s annual survey of foreign portfolio investment) against the US trade deficit.

almost-a-dollar-crisis-4

At the end of 2006, private demand for US portfolio investments disappeared. Net private flows, on a rolling 12m basis, went from around $200 billion to negative $350 billion. The gap between the trade deficit and private portfolio flows consequently became quite large. Close to a trillion dollars.

And that gap corresponded to weakness in one of the world’s few truly floating exchange rates (though PBoC and other big players no doubt have an impact of how the dollar floats against the euro).

almost-a-dollar-crisis-2

What made up the gap, avoiding an outright crisis that would have forced the US to adjust far more rapidly? Truly unprecedented reserve growth – as private capital flooded emerging economies, including emerging economies with large current account surplus. That led to an extremely high level of official inflows into the US.

almost-a-dollar-crisis-3

It is possible that the rise in official inflows drove up US market prices (and pushed down yields) and thus pushed private investors out of the US market. But the strong correlation between the fall in private demand for US assets and the dollar-euro suggest another dynamic was at work. Private investors shifted from financing the US to financing the emerging world, and emerging market governments channeled that flow back to the United States.

Nouriel and I clearly under-estimated the willingness of the emerging world to accumulate reserves and thus to finance a US deficit. Dooley, Garber and Folkerts-Landau got that right.

But the ability of the US to attract the external financing it needed to sustain its large deficit before the Fall 2008 crisis was – I would submit – a bit more of a dicey proposition than some commentary now suggests.

What did international economists and a host of others (look at the IMF’s 2007 report on the United States) really get wrong?

They thought the rise in foreign demand for US corporate bonds (a category that includes asset backed securities, including “private mortgage backed securities”) meant that risk was truly being dispersed away from the heart of the American financial system. Few realized that a lot of the demand was coming from SIVs sponsored by US institutions — and that a host of European banks with large dollar balance sheets (often managed in London) had effectively become part of the core of the US financial institutions.

14 Comments

  • Posted by don

    Second graph is very interesting. Still disagree with the characterization of ‘we need official inflows to cover the trade deficit’ – I put the direction of causality the other way.

  • Posted by Twofish

    bsetser: When US growth slowed and global growth did not, private investors (limited) willingness to finance the US deficit disappeared.

    I think that one thing is missing is interest rates. If you look at the graph of fund flows, it matches exactly the graph of interest rates. In particular in mid-2007, the Fed started massively cutting interest rates when the ECB didn’t.

    Two seconds after it gets word that interest rates have changed then happens all of the computers on Wall Street start dumping US bonds and start buying European ones.

    The other thing tha I disagree is with the notion that the emerging world was recycling US capital. The US was being financed with capital which was being generated in China and the Middle East. China could only run massive trade surpluses because it had a store of local capital which it could use to sterilize its reserves. Without that store of capital, you would have had massive inflation.

    bsetser: What did international economists and a host of others (look at the IMF’s 2007 report on the United States) really get wrong? They thought the rise in foreign demand for US corporate bonds (a category that includes asset backed securities, including “private mortgage backed securities”) meant that risk was truly being dispersed away from the heart of the American financial system. (…) Few realized that a lot of the demand was coming from SIVs sponsored by US institutions

    This is the part that I find scary, which is that where the money was flowing and where it was going was pretty common and standard knowledge to anyone in the banking industry. There was a *huge* disconnect between the academic community, government policy makers, and people that actually do finance.

  • Posted by bsetser

    the emerging world was:

    a) investing its own current account surplus in the us and europe
    b) recycling some net private inflows due to a portfolio shift toward ems from the us and europe.

    eg in 07 and the first 1/2 of 08, total em reserve and SWF growth easily topped the emerging world’s current account surplus. so both factors were at play. I should have been clear on this.

    and let’s just say that the banks weren’t all that keen to dispell the regulators notion that securitization was dispersing risk.

  • Posted by Cedric Regula

    I guess we could call it currency crisis lite, then Brad and Nouriel could be a little bit right. Then I’ll at least have some theoretical explanation for all the money my foreign bond manager made me. Course he did short the Euro at more or less the right time.

    It would be interesting to see “net portfolio flow” data broken down into equity and fixed income components, if the data is available at that level. Generally, equity investors are not that sensitive to interest rates when a bull market is going on somewhere. But porfolio allocations change to depending on circumstances.

    The EM equity market boom is well known, but I have been wondering how that works with China. The Shanghai market is now 10T yuan in market cap which really isn’t very much, even tho it has doubled again over early 2008 levels. Of course the bulk of the trading on Chinese stocks is supposed to happen in Hong Kong, and many have ADRs on Wall Street. But I’m curious how the flows really work and whether or not this all actually ends up in USD, HKD and RMB transactions.

  • Posted by 4degreesnorth

    I suggest turning the blame game onto JP Morgan: in the nineties – and I was in the industry – there was a model of risk assessment that was developed by that firm, and if I recall well, distributed freely by them post LTCM. As a result most of the industry adopted basically the same risk assessment model, only adding their own idiosyncratic twists to it. Talk about herd mentality!

    Elsewhere, I remember disagreeing politely on this blog with you on BW II. BW II is as stable – or sane – as M.A.D. was in the scary old days. You have always been right in questioning whether China was eager in financing the real estate habit of Americans. But the real question is, until they manufacture a true Chinese consumer, what other choice do they have than to park their money in the US, government or otherwise.

  • Posted by Twofish

    quote: If economists try to predict crises they will get it wrong, and that will reduce their credibility when they try to warn of risks.

    This is a bit odd. I can predict with pretty high certainty that there will be some financial crisis around 2015. I have no idea what it will be right now, but I should have a better idea in two years or so.

    One problem here is “free will” versus “determinism.” Economists like to use deterministic models, which poses a problem is that they exclude free will. The reason I don’t know what exactly the cause of the crisis of 2015 is is because the nature of the crisis depends a lot of what decisions people make now and in the next year or two.

    I can be confident that there will be some crisis around 2015, because social institutions take about five years to adjust. Someone will make some decisions, these decisions will have unforeseen consequences, and it will take about five years for those consequences to grow large enough to cause something dramatic to happen.

    bsetser: let’s just say that the banks weren’t all that keen to dispell the regulators notion that securitization was dispersing risk.

    If you have a set of institutions in which people have to act in massively non-self-interested ways to get things to work, then that system is very flawed.

    On the other hand, with a few exceptions, most banks really had no idea what their risk exposures where.

    4degreesnorth: I suggest turning the blame game onto JP Morgan: in the nineties – and I was in the industry – there was a model of risk assessment that was developed by that firm, and if I recall well, distributed freely by them post LTCM.

    But that VaR model worked quite well at JPMorgan. If you actually use VaR correctly you end up with the fact that investments in super-senior CDS’s were bleeding insane, which is what JPMorgan itself concluded.

  • Posted by purple

    The imbalances written about by Wolf and the like are just symptoms of chronically weak demand relative to capacity. Credit innovations and public deficit spending have floated the world economy along for quite some time, but there is massive excess capacity that must be flushed from the system if capitalism is to become healthy again – as measured by its own standards.

  • Posted by Stormy

    The current account balance may yet take us down. Unless it begins to gain some equilibrium, all the Fed and Treasury will be doing is throwing money at the consumer and hope some of it catches.

    What is the current account balance as a percentage of GDP?

  • Posted by Yoda

    http://globaleconomicanalysis.blogspot.com/2009/07/free-money-runs-out-congress-authorizes.html

    Obama, Pelosi, and democrats waste taxpayer money. Unbelievable. Why not, since Treasury and Bernanke Co has unlimited dollar supply.

  • Posted by FollowTheMoney

    emergin world was indeed attracted to u.s. dollar as “safety”…however as decoupling becomes more imminent in years ahead the chances of this decrease.

    Since the Fed has decided to inflate her way out of the troubles,there’s likley a good possibility dollar weakness may continue in 2nd half of 2009.

    For the record i expect GOLD to break through $1000/oz within 30 days of this note.

  • Posted by Pax Americana

    Agree with the Decoupling Prognosis, to a certain extent as the PRC goal is to reinforce the use of RMB as a global currency by the facilty of bi-lateral Agreements.Real Decoupling from Fate of American consumers make take longer.

  • Posted by Twofish

    purple: There is massive excess capacity that must be flushed from the system if capitalism is to become healthy again – as measured by its own standards.

    This is madness. You have a perfectly good factory or apartment building that is idle, you can’t figure out what to do with it and the solution is *burn it down???*

    If there really is excess capacity then fire up the helicopters and drop money from the skies until the capacity gets used, which is exactly what has been done and it seems to be working.

  • Posted by smoody

    I remember your paper with Roubini. I’ve read it several times. I first read it looking for an explanation for the excess liquidity that had been building in Kazakhstan since the end of 2002. The paper didn’t directly address the issue, but I certainly bought into your conclusion. In subsequent readings however I began to suspect–certainly after 2007– that the paper was about global excess liquidity (imbalances?) and that the real danger was not the collapse of the dollar, but the the US’s loss of the ability to conduct its monetary policy. In short, Greenspan’s conundrum which, in fact, fed the housing bubble and build up of excess leverage in the financial sector. So, from my perspective anyway, everyone missed the call because (1) they didn’t understand Fed monetary policy failed in 2004 and (2), even if they called the housing crisis, they didn’t connect it to the global excess liquidity issue and (3), to this day, few point to the yen and dollar carry trades that drove Eastern European housing and stock markets to heights of folly in the days of the bubble. For me, your paper was very insightful
    even if you–like me and everybody else–missed the most important point.

  • Posted by Finance Dollar

    I think international macroeconomists have been looking for a dollar crisis for quite some time, and they believed that such a crisis would bring on the meltdown. Instead, the meltdown occurred for other reasons and paradoxically reinforced the position of the dollar (and, for the moment, many of the structural imbalances that have troubled international economists).”The paper didn’t directly address the issue, but I certainly bought into your conclusion. In subsequent readings however I began to suspect–certainly after 2007– that the paper was about global excess liquidity (imbalances?) and that the real danger was not the collapse of the dollar, but the the US’s loss of the ability to conduct its monetary policy. In short, Greenspan’s conundrum which, in fact, fed the housing bubble and build up of excess leverage in the financial sector
    Finance Dollar

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