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Geoeconomics, in pictures

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This post is by Brad Setser and Paul Swartz of the Council on Foreign Relations.

No doubt today’s GDP release will attract the lion’s share of the econoblogosphere’s attention. But sometimes it is a good idea to counter-program.

Paul Swartz, I and others at the Council’s Center for Geoeconomic Studies have been – at the prodding of our boss – trying to come up with indicators that capture “Geoeconomic” risk. Or at least to develop measures some key “geoeconomic” concepts, with geoeconomics defined as anything that touches on both the economy and geopolitics. An example might be the gapminder chart we did for the Council’s multimedia spectacular on the financial crisis that touches on the question of whether the G-7 still brings together the world’s most economically powerful countries.

I am not sure that we have succeeded, though I do think we have come up with some interesting ideas – ideas, though, that need to be stress tested with a bit of external scrutiny. Call this a very rough working draft.

One idea has been to look at what share of the world’s total economic output is produced by democratic countries. To do this, we weighted output by a measure of a country’s political openness (from the Polity IV project). A low score implies that all of the world’s output is produced in countries that are not democracies. A high score means all the output is produced by countries that are well-functioning democracies. And a score in the middle means something in the middle – either there are a lot of economically large democracies and a lot of economically large autocracies, or that a lot of global output is produced by countries that aren’t total autocracies nor perfect democracies.

The results are interesting; the end of the Cold war increased the share of output produced by the world’s democracies. But China’s ability to grow rapidly with significantly democraticizing has made the global economy a bit less “democratic” (in the sense that less of the world’s output is produced by democracies).

gdpbygoveranceforms

That implies that if current economic trends – meaning the gap between the rate of growth between autocratic and more democratic countries — continue, the share of global output produced by democracies will decline over time.

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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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Not necessarily always stabilizing …

by Brad Setser

One common argument — at least prior to the crisis — was that sovereign investors, because of their long-term focus, were generally a stabilizing presence in the market. Sovereign wealth funds in particular. And presumably central bank reserve managers as well. After all, in many cases, the line between a sovereign wealth fund and an aggressively managed central bank reserve portfolio is rather thin.*

These arguments were always a bit hard to assess. There isn’t enough data on the actual actions of sovereign funds to evaluate their true impact on the market. Did sovereign funds step up their purchases of equities when the markets went down? Or were they sellers then?

The available data does suggest that reserve managers have generally acted to stabilize the currency market. Central bank demand for dollars tends to rise when the dollar is going down. But the available evidence also suggests that reserve managers added to the instability in the credit markets during the recent crisis.

Central banks rather suddenly stopped buying Agency bonds, pushing Agency spreads up — at least until the Fed stepped in.

And, as the latest BIS bank data makes clear, they also withdrew large sums from the international banking system. The following chart comes table 5c in the BIS locational banking data; it shows the annual change in the deposits that the world’s reserve managers hold in the banking system.**

central-bank-deposits1

To be sure, central bank reserve managers weren’t the only ones pulling money out of big international banks. Money market funds were too. But the loss of $400 billion in deposits — $220 billion in q4, another $170 billion in q1 — from the world’s reserve managers added to the pressure a lot of banks faced. Including, I would guess, some European banks with large dollar balance sheets; that is one reason why there was “extraordinarily high demand for dollars from foreign financial institutions” during the crisis.

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And now, the rest of the story: long-term portfolio flows have fallen by more than the trade deficit

by Brad Setser

The goods news: the US trade deficit has shrunk. On a rolling 12m basis the trade deficit is down to around $500 billion, and the data from the last few months suggests that it should fall even further.

The bad news: the US trade deficit hasn’t shrunk by as much as foreign demand for US long-term assets.

trade-deficit-v-portfolio-flows-5

My graph only showed inward portfolio flows. That isn’t the entire balance balance of payments. But inward and outward FDI flows tend to offset each other. And in general Americans have been adding to their foreign portfolio, not reducing their foreign holdings. That means the (remaining) deficit is increasingly financed by short-term flows, which isn’t the most comfortable thing in the world.

All this is pretty clear if you look at the details of the last TIC data release (already covered in depth by Rachel). Over the last three months, private investors reduced their US holdings by over $100 billion (line 31). That total was offset by the repayment of the Fed’s swap lines — but the long-term flow picture isn’t great. Net portfolio inflows over the last 12ms totaled $188 billion (line 19). After adjusting for repayment of ABS, that total falls to zero (lines 20 and 21).

As the following graph shows, net private demand for long-term US assets — that is gross long-term private portfolio inflows net of US portfolio outflows — started to disappear in late 2006, and then took another down leg after the subprime crisis broke in August 2007. And over the last 9 months, official demand for US long-term bonds also disappeared — as reserve growth slowed (until recently) and central banks moved in mass toward short-term treasury bills.

trade-deficit-v-portfolio-flows-11

The split between official and private flows in the chart reflects my adjustments to the TIC data – but my adjustments basically just make the TIC data match the US survey data and the revised BEA data on official flows.* My adjustments change the official/ private split, but not the total.

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“A more balanced economy might allow the world to live with a less perfect financial system”

by Brad Setser

Mike Dooley and Peter Garber argue (at VoxEU) that the recent crisis has nothing to do with “Bretton Woods 2” — an international monetary system where reserve growth in the “periphery” financed deficits in the center. They write:

“the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries …. [NOT BY] ….”current account imbalances, particularly by net flows of savings from emerging markets to the US,” “easy monetary policy in the US” or “financial innovation. … the idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us.” *

The authors of Box 1.4 of the IMF’s Spring 2009 World Economic Outlook also attribute the current crisis to risk management failures in large financial institutions and weaknesses in the regulation and supervision of such institutions.** The role of imbalances are downplayed, as a “disorderly exit from the dollar has not yet been part of the crisis narrative.”

The last point is hard to refute: the dollar rallied during the most intense phase of the crisis.*** Reserve growth stopped, but that was because private money moved out of the emerging world and into the dollar, yen and swiss franc after the crisis – not because the world’s central banks lost confidence in the dollar. The proximate cause of the most recent phase of the crisis was a collapse in private financial intermediation, not a collapse in key central banks’ willingness to finance US.

But the absence of the kind of dollar collapse that many postulated might bring Bretton Woods 2 to an end doesn’t imply – in my view – that there was no connection between a global system marked by large inflows from the emerging world and the current crisis. The key issue is whether or not the large net flow from the emerging world to the US and Europe created conditions that facilitated, directly or indirectly, the failure of private risk management.

Three potential connections come to mind:

A rise in offshore dollar deposits by central banks provided some of the financing for the growth in banks’ dollar balance sheets. Central bank inflows into offshore money market funds had a similar impact.

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The savings glut. Controversy guaranteed.

by Brad Setser

Few topics are quite as polarizing as the “savings glut.” The very term is often considered an attempt to shift responsibility for the current crisis away from the United States.

That is unfortunate. It is quite possible to believe that the buildup of vulnerabilities that led to the current crisis was a product both of a rise in savings in key emerging markets, a rise that — with more than a bit of help from emerging market governments — produced an unnatural uphill flow of capital from the emerging world to the advanced economies, and policy failures in the U.S. and Europe.

The savings glut argument was initially put forward to suggest that the United States’ external deficit was a natural response to a rise in savings in the emerging world – and thus to defuse concern about the sustainability of the United States’ large external deficit. But it was equally possible to conclude that the rise in savings in the emerging world reflected policy choices* in the emerging world that helped to maintain an uphill flow of capital – and thus that it wasn’t a natural result of fast growth in the emerging world. This, for example, is the perspective that Martin Wolf takes in his book Fixing Global Finance. Wolf consequently believed that borrowers and lenders alike needed to shift toward a more balanced system even before the current crisis.

From this point of view, the savings glut in the emerging world — as there never was much of a global glut, only a glut in some parts of the world — was in large part a result of product of policies that emerging market economies put in place when the global economy — clearly spurred by monetary and fiscal stimulus in the US — started to recover from the 2000-01 recession. China adopted policies that increased Chinese savings and restrained investment to try to keep the renminbi’s large real depreciation after 2002 – a depreciation that reflected the dollar’s depreciation – from leading to an unwanted rise in inflation. The governments of the oil-exporting economies opted to save most oil windfall – at least initially. Those policies intersected with distorted incentives in the US and European financial sector – the incentives that made private banks and shadow banks willing to take on the risk of lending to ever-more indebted households (a risk that most emerging market central banks didn’t want to take) to lay the foundation for trouble.

On one point, though, there really shouldn’t be much doubt: savings rates rose substantially in the emerging world from 2002 to 2007. Consider the following chart – which shows savings and investment in emerging Asia (developing Asia and the Asian NIEs) and the oil exporters (the Middle East and the Commonwealth of independent states) scaled to world GDP.

savings-glut-weo-09-6-1-redone

Investment in both regions was way up. But savings was up even more.

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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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More on the fall in private borrowing and the rise in the fiscal defict

by Brad Setser

The chart that supported my previous post attracted a fair bit of attention. But it was cobbled together at home and only looked at data over the past few years. With help from the CFR’s Paul Swartz, I looked at the quarterly data over a longer time period.

The story is clear. Government borrowing has increased dramatically. It topped 15% of GDP in the last two quarters of 2008. In 2007 and early 2008 it was more like 3% of GDP. But private borrowing has fallen equally sharply. Total borrowing by households and firms fell from over 15% of GDP in late 2007 to a negative 1% of GDP in q4 2008.

private-v-public-borrowing-thru-08-11

Negative borrowing by households and firms means, I think, that households paid down their debts in the fourth quarter.

It hardly needs to be noted that the fall in borrowing by households and firms in late 2008 was exceptionally rapid. A stronger economic cycle implied that the magnitude of counter-cyclical fiscal policy also needed to be ramped up.

The disaggregated data on borrowing by households and firms is also interesting. Household borrowing rose to record levels in 2003 and remained high through early 2006. Household borrowing fell in 2007, but for a time this fall was offset by a rise in borrowing by private firms. Borrowing by firms actually peaked in the middle of 2007 at a higher level than during the dot come investment boom. Chalk that up to a surge in leveraged buyouts and stock buybacks.

private-v-public-borrowing-thru-08-21

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More government borrowing doesn’t necessarily mean more total borrowing

by Brad Setser

The United States is borrowing less from the rest of the world than it was. That is true even though the US Treasury is borrowing more from everyone, including more from the rest of the world.

The amount the US borrows from the world is the gap between the amount that Americans save and the amount that Americans invest at home. That turns out to be equal to the current account deficit. And for the US, it so happens that the current account deficit is about equal to the (goods and services) trade deficit. The trade deficit — at least in the first quarter of 2009 — was way down. In dollar terms, it was about half as big as it was in the first quarter of 2008. That implies that the US is borrowing far less from the world now than at this time last year.

Why hasn’t the expansion of the fiscal deficit pushed the amount the US borrows from the world up? Simple. American households and businesses are borrowing a lot less, so the total amount of money that Americans are borrowing isn’t rising.

A picture is generally more effective than words. The following chart shows borrowing by various sectors of the economy — households, firms and the government.** All data comes from the Fed’s flow of funds, table F1.

gov-v-household-borrowing

As the chart shows, the rise in government borrowing came even as other sectors of the economy were borrowing a lot less. Household borrowing peaked in 2006. Borrowing by firms actually peaked in 2007 — remember all the leveraged buyouts then. Borrowing by both households and firms fell precipitously in 2008. As a result, total borrowing by households, firms and the government fell in 2008.

The last data point in the flow of funds data is from the fourth quarter of 2008. Q1 2009 data isn’t yet available, but the fact that the trade deficit fell so much in Q1 2009 suggests that total US borrowing isn’t rising — at least not faster than US savings.

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