Brad Setser

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The (almost) dollar crisis of 2007 …

by Brad Setser

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

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The faster the rise, the bigger the fall?

by Brad Setser

Cross-border bank claims – according to the Bank for International Settlement (BIS) — shrank in the first quarter, though at a slower pace than in the fourth quarter. That basic storyline also holds for the emerging world: the total amount the major international banks lent to the world’s emerging economies fell in the first quarter, but not at quite the same rate as in the fourth quarter.

The fall in cross-border flows is often presented as evidence of the dangers posed by financial protectionism – as governments that are now forced to backstop global banks aren’t inclined to backstop “their” banks global ambitions.

But there may be a simpler explanation for the fall in cross-border claims: the boom was unsustainable. Cross-border loans to the emerging world grew at an incredible clip from 2005 to mid 2008. Total lending more than doubled in less than three years, rising from a little under $1.4 trillion to $2.8 trillion.

bis-gross-claims-on-ems3

Some of that rise was offset by a rise in the funds emerging economies had on deposit in the international banking system. Emerging market central banks in particular were putting some of their rapidly growing reserves on deposit with the big international banks. But there was still a huge boom in lending — one that probably couldn’t have been sustained no matter what.

Bank loans to emerging economies did fall sharply in q4 2008 and q1 2009, as one would expect given the magnitude of the crisis. For all the talk about financial protectionism, I suspect that they would have fallen far faster if governments hadn’t stepped in to stabilize the international banks — and to mobilize a lot of money for the IMF so the IMF could lend more to emerging economies, reassuring their creditors.

Cross-border claims are falling at a bit faster rate than in the 1997-98 emerging market crisis. Claims on emerging economies are down by about 20% from their June 2008 peak. But cross-border claims also rose at a far faster rate in the run-up to the current crisis.

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Don’t ignore the adjustment that has taken place; the US trade deficit is half its size this time last year …

by Brad Setser

Most reporting on the May trade data tried to fit it into the “green shoots” meta-narrative, thanks to the small uptick in exports. Never mind that total exports were about equal to their level in March even after the May uptick– and that about half the uptick between May and April came from a sharp rise in petroleum exports (see Exhibit 9). I have a hard time seeing how that signals a sustained uptick in US activity.

On a y/y basis, the fall in exports does seem to have stabilized. Moreover, the y/y fall in exports seems to have stabilized with a bit before the fall in imports stabilized, and the percentage fall in non-oil imports (around 25% y/y) is a bit larger than the percentage fall in non-oil exports (around 20% y/y).

trade-may-09-12

But y/y changes don’t tell us all that much. Levels are what count.

Real (goods) exports and especially imports have been essentially flat for the last three months or so. The Los Angeles and Long Beach port data suggests nothing much changed in June. That is progress. Exports, imports and indeed activity were all in free fall for a while in q4 and q1. But the trade data – backward looking data, to be sure – still fits comfortably with Jan Hatzius’ argument that final demand is going sidewise more than recovering.

trade-may-09-2

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The CFR’s financial crisis guide

by Brad Setser

It isn’t quite a yield curve mambo, but Paul Swartz and I did pull together a few Google motion charts to help illustrate the origins — at least in our view — of the financial crisis of 2007-08. Click on motion charts after following this link.

What’s more, the Council’s website has an interactive tool that lets you play with the charts …

Enjoy the charts over the holiday weekend (at least in the United States). And let me know what you think. Are there any charts that we used that didn’t work? Are there charts that we should have included but didn’t?

Where is the spillover? China’s stimulus isn’t doing much to support Japanese demand

by Brad Setser

Japan’s exports to China are still way down on a y/y basis in May, despite China’s stimulus.

Shipments to China, Japan’s biggest trading partner, fell 29.7 percent, more than April’s 25.9 percent. Exports to Asia slid 35.5 percent from 33.4 percent a month earlier.

hat tip, Yves Smith of Naked Capitalism.

That isn’t good news. US exports to China are also down (15.6% y/y, through in the first four months of 2009, though a bit less in April itself). The eurozone’s exports to China are also down — though the 8% or so fall y/y fall in the eurozone’s exports to China seems a bit more modest than the fall in Japan’s exports to China.

China’s economy may have expanded over the last year, but that expansion clearly hasn’t fed through into more Chinese demand for US, European or Japanese goods.
Not yet at least. Pick your explanation. China’s stimulus may have been directed at domestic producers. The process of substituting Chinese components for Japanese components in China’s exports may be accelerating. Or China’s recovery just may not be quite as robust as some believe.

The best that can be said of Japan’s May trade data is that Japan’s exports to China aren’t down as much as Japan’s exports to the US and Europe.

Shipments to the U.S. fell 45.4 percent in May after dropping 46.3 percent in April, the ministry said. Exports to Europe slid 45.4 percent from 45.3 percent.

The y/y comparison will get more favorable soon. But there is now real way to put all that positive gloss on Japan’s 41% year over year fall in exports. It is an epic fall.

Japan’s May 2009 exports were even a bit lower than its April 2009 exports. There may be some benign explanation for the slight dip in May, but I don’t think there is any way to suggest that the Japan’s May trade data suggests a robust global recovery.

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

by Brad Setser

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.

us-current-account-q1-09-1

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.

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The good and bad news in the World Bank’s China Quarterly

by Brad Setser

The good news in the latest World Bank China Quarterly:

One. China is growing, thanks to China’s government. The World Bank estimates that the government’s policy response will account for about 6 percentage points of China’s 7.2% forecast growth (p. 8). That’s good. There is a big difference between growing as 7% and growing at 1%. This was the right time for China’s government to “unchain” the state banks. Ok, it would have been better if China had allowed its currency to appreciate back in late 2003 and early 2004 to cool an overheated economy instead of imposing administrative curbs on bank credit and curbing domestic demand. Then China might not have ever developed such a huge current account surplus and avoided falling into a dollar trap. But better late than never: this was the right time to lift any policy restraints on domestic demand growth.

China has, in effect, adopted its own version of credit easing. It just works through the balance sheets of the state banks rather than through the balance sheet of the central bank. Andrew Batson:

By some indicators, credit in China is even looser than in the U.S., where the Federal Reserve has extended unprecedented support to private markets. … China’s methods for pumping cash into the economy are quite different from those of other major economies. Its banks, almost all of which are state-owned, made more than three times as many new loans in the first quarter as a year earlier. Central banks in the U.S., Europe and Japan lack such control over lending, and have instead used extremely low interest rates and direct purchases of securities to support credit.

Two. China’s fiscal deficit will be closer to 5 percent of GDP rather than 3 percent of GDP. That’s cause for celebration in my book. Last fall I was worried that the desire to limit the fiscal deficit to three percent of GDP would mean that there was less to China’s stimulus than met the eye (or hit the presses). I was wrong. If the likely future losses on the rapid expansion of bank credit are combined with the direct fiscal stimulus, China almost certainly produced a bigger stimulus program than any other major economy.

Three. China’s current account surplus is now projected to fall in 2009. Exports still haven’t picked up — and we now have data through the first five months of the year. Imports by contrast are starting to pick up. That shows up clearly in a chart of real imports and real exports, a chart that draws on data that that the World Bank’s Beijing office generously supplied me:

china-world-bank-q2-09-1

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Read Brender and Pisani’s “Globalised finance and its collapse”

by Brad Setser

I highly recommend Anton Brender and Florence Pisani’s recent monograph, “Globalized finance and its collapse.” In a lot of ways, it is something that I wish I could have written. I don’t agree with every detail, but in my view they get the broad story right.

Brender and Pisani both teach at Paris-Dauphine. But Anglo-Saxon chauvinism shouldn’t get in the way of appreciating quality work. And in this case, there is no excuse: the translation (by Francis Wells) is superb.

In some deep sense, Brender and Pisani have updated the core arguments of Martin Wolf’s Fixing Global Finance (also highly recommended) to reflect many of the things what we all have learned in the last nine months of crisis.

Like Martin Wolf, Brender and Pisani recognize that globalization took an unusual turn over the past several years: the globalization of finance resulted in a world where the poor financed the rich, not one where the rich financed the poor. And what’s more, this “uphill” flow was essentially a government flow. Despite the talk of the triumph of private markets over the state a few years back, the capital flow that defined the world’s true financial architecture over the past several years was the result of the enormous accumulation of foreign exchange reserves in the hands of the central banks of key Asian and oil-exporting economies.

Dooley and Garber recognize this. They don’t pretend that private investors in the emerging world drove the uphill flow of capital. But Dooley and Garber also assert that there is no connection between this uphill flow and the current crisis. In a March Vox EU piece they wrote:

“We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US … Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future … Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity … This is not the crisis that actually hit the global system. But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.” Emphasis added.

It actually isn’t that hard to find examples of how low returns on “safe” investments induced more risk-taking throughout the system, especially private intermediaries started to believe in the essential stability of Bretton Woods 2. The Wall Street Journal recently reported that many bond funds underperformed their index in 2008 because their managers had been taking on more risk to juice returns in the good years, and thus went into the crisis underweight the safe assets that central banks typically hold. US money market funds that lend ever-growing sums to European commercial banks were making a similar bet. As were the European banks that relied on wholesale funding to cover their growing portfolios of risky dollar debt. The inverted yield curve forced vehicles that borrow short and lend long to either go out of business or take ever more credit risk — and as volatility fell and spreads compressed, there was a constant temptation to take on more leverage to keep profits up. The pressures to take more risk were there.

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China’s recovery still isn’t adding (much) to global demand

by Brad Setser

At least not for anything other than commodities, where Chinese demand — and Chinese stockpiling — clearly has had an impact. Exports to China from the US and Korea continue to be pretty weak. Exports from the US have bounced back from their winter lows, but still well below their pre-crisis levels. And exports from Korea to China are still down far more than I would have expected.

korea-us-china-may-09-13

China’s industrial production is up about 10% y/y (9%) even though exports and imports are both down around 25% y/y in nominal terms.

Lets do some very rough ballpark math. I’ll start by assuming that about 40% of China’s industrial production — pre-crisis — was exported. I think that is about right, but I don’t have the actual number. Help here would be appreciated. If industrial production for export was 40% of total production and if it fell by around 25%, the 60% of industrial production that is far domestic use would need to be up around 30% to generate 9% y/y growth.

That is a big increase. And it isn’t totally implausible. Lending and investment are way up. So are stimulus driven auto sales. But it also raises the question of why it took China so long to really stimulate domestic demand if it had such latent capacity to grow without relying on exports.

Let’s also assume that imported components constituted around 60% of Chinese imports (consistent with a world where China accounts for only about half of the value-added in Chinese exports) a year ago. Here imports would fall in line with exports. But to produce an overall 25% fall in imported demand, nominal imports for domestic use also would need to fall by 25%.

Such a fall could come from a 25% fall in the price of the goods China imports for its own use (presumably a basket that includes a lot of commodities). Or from a 10% fall in the goods China imports and a 15% price fall. Or a 35% fall in price and a 10% rise in actual imports.

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Just who bought all the Treasuries the issued in late 2008 and early 2009?

by Brad Setser

As Dr. Krugman notes, the Fed’s flow of funds data leaves little doubt that — at least during the first quarter — the rise in public borrowing was fully offset by a fall in private borrowing. An updated version of the chart I posted last week comparing government and private borrowing can be found on the website of the Council’s Center for Geoeconomic Studies.

Total US borrowing by the non-financial sector (annualized) was under $1.4 trillion in the first quarter — down from $1.9 trillion in calendar 2008 and $2.5 trillion in calendar 2007. In the first quarter, Americans borrowed less, at an annualized rate than they did in 2003.

The federal government borrowed over $1.4 trillion – -and if throw in state and local governments, total public borrowing topped $1.55 trillion. That isn’t a small sum. But households were borrowing (they actually paid down their outstanding debt in the first quarter). And modest borrowing by corporations was offset by a fall in borrowing by noncorporate business. Firms and households combined to reduce their borrowing by a bit less than $200 billion ($184.1 billion). To put that in perspective, households and firms borrowed over $2 trillion in 2006. That is an epic fall.

Borrowing less in aggregate translated into borrowing less from the rest of the world. If the flow of funds is right, the current account deficit in the first quarter in the first quarter was under $300 billion dollars ($293 billion according to table F107). $300 billion is closer to 2% of US GDP than 3% of US GDP. The result, obviously, is less need to borrow from the rest of the world — or to sell equity to foreign investors — to finance the United States import bill.

Who bought all the Treasuries the US government has issued in the last four quarters of data (q2 2008 to q1 2009)? Foreign demand for Treasuries — as we have discussed extensively — hasn’t disappeared, unlike foreign demand for other kinds of US debt. But foreign demand hasn’t increased at the same pace as the Treasury’s need to place debt. The gap was filled largely by a rise in demand for Treasuries from US households.

treasury-demand-q1-09-1

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