If I had to pick a single graph to explain the evolution of the United States’ balance of payments – and thus, indirectly, the entire story of the world’s macroeconomic “imbalances” – this would be it.

All data is in dollar billions, and is presented as a rolling four quarter sum.*

The red line is the United States current account deficit.

The black line is the United States financing need – defined as the sum of the current account deficit plus US outward FDI and US purchases of foreign long-term securities.** The dip in the total US financing need from mid 2005 to mid 2006 isn’t real. It reflects the impact of the Homeland Investment Act, a holiday on the repatriation of the foreign profits of US multinationals that produced a sharp fall in outward FDI.*** The rise in the United States financing need over the course of 2007 by contrast is real; American investors bought the decoupling story and wanted to invest more abroad.

The shaded area represents official demand for US assets. The inflows from central banks that report data to the IMF and Norway are known. The inflows from central banks that don’t report and other sovereign funds are my own estimates. The key countries that do not report reserves are – in my judgment – China, Saudi Arabia and the other countries in the GCC. I have assumed that the dollar share of their reserves is closer to 70% than 60% (supporting evidence). I by contrast have assumed that the GCC’s sovereign funds have a diverse portfolio.

What does the graph tell us?

In my view, three things:

First, the rise in the US current account deficit from 2002 to 2006 is associated with a rise in official demand for US assets. The quarterly IMF data doesn’t extend back to the late 90s – or to the early 1980s. But trust me, that is a change from past periods when the US current account deficit expanded. To be sure, private investors abroad were also buying US assets. But the rise in the overall US financing need associated with the rise in the current account deficit wasn’t financed by a comparable rise in private demand for US assets.

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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.

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

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On Friday I tried to show why the US net international investment position deteriorated in 2008 – and also why it didn’t deteriorate in the previous years. Even after the market and currency gains of the past evaporated in 2008, the US net debt isn’t quite as big as an analyst who looked at the United States large cumulative current account deficit would expect. Some of the debt that the US thinks it sells to the rest of the world every year seems to disappear when the US goes out and tries to count the total amount owes the world – and how much equity in US companies have been sold to foreign investors.*

Yet even if the US data doesn’t show quite as much debt as it probably should, it still tells a lot going about what was on in the US – and the global – economy in the run up to the crisis.

It is consequently tempting to try to do a bit of forensic accounting to help understand how vulnerabilities built up. One thing quickly becomes clear. The US was piling up external debts in the run-up to the crisis even if the United States’ net international investment position wasn’t deteriorating.

The data in the NIIP can be disaggregated into debt and equity fairly easily. It is also fairly easy to separate out net official and net private claims. There isn’t a separate breakout for “official” investments in equities – as central bank and sovereign funds’ equity investments are aggregated together with their investments in US corporate bonds. But the US survey data indicates that official holds of equities were over three times official holdings of corporate bonds in the middle of 2008, so I don’t feel too bad considering “other official assets” a proxy for central bank and sovereign funds’ investment in US equities.

But don’t get bogged down in the details. There is no doubt that the US was clearly racking up debts to both official and private creditors in the run up to the crisis. Net US external debt (US borrowing from the world, net of US lending to the world) is now close to 40% of US GDP — a fairly high level for a country with a modest export sector.

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For a long time, large US trade and current account deficits didn’t push up the total amount the United States owed to the world, at least not if the market value of US investment abroad was netted against the market value of foreign investment in the US. The net international investment position of the US stayed around negative $2 trillion even as the US chalked up $500 billion, $600 billion even $700 billion annual deficits, defying those who projected that rising deficits would put the US external debt on an unsustainable trajectory.

Why? The euros’ rise pushed up the value of US investments in Europe. The US external position actually benefits from a falling dollar, as most US liabilities are in dollars while many US assets are not. And foreign equities did better than US equities.

Those who argued that the US was attracting funds because it was the best place in the world to invest generally forgot to note that during the period when the US deficit was rising the US was consistently doing better on its investments abroad than foreigners were doing on their investment in the US.

That changed in 2008. The US borrowed $505 billion from the world.* The dollar’s rise reduced the value of US investment abroad by $685 billion ($583 billion without including direct investment). Foreign portfolio equity investments in the US fell in value by about $1.3 trillion. But US portfolio equity investments abroad fell in value by about $1.9 trillion. Add in changes in the value of US and foreign bonds and changes in market prices reduced the value of US portfolio investment abroad by $720 billion more than the changes in market prices reduced the value of foreign portfolio investment in the US. The size of that total losses rises if changes in the market value of US and foreign direct investment are also factored in. All told, changes in market prices (other than exchange rate changes) led to a $1.7 trillion deterioration in the United States net investment position.

Combine those valuation changes with ongoing US borrowing and the net international investment position deteriorated in a rather dramatic fashion. The US NIIP — the blue line in the following graph — deteriorated by $2.5 trillion if FDI is valued at market prices.

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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.

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Events in Iran (rightly) dominate the headlines, along with the Obama Administration’s plans to revamp the United States’ system of financial regulation.

And it doesn’t take much to overshadow the release of the United States’ balance of payments data, as it largely tells us things that we already know — whether from the trade data (the trade deficit is way down) or the TIC data (private investors didn’t put much money in the US in q1).

But there are still stories to be found in the balance of payments data. Give the US a bit of credit. No other country releases as much detail about its balance of payments as the United States. Play with the interactive tables for a while; it is hard not to be impressed.

I have a particular reason to pay attention to those details. I have long argued — actually screamed at the top of my lungs to anyone who would listen — that central banks and sovereign funds were the main source of financing for the US current account deficit from the start of 2007 to the fourth quarter of 2008. And at long last, I can now point to a genuine official data release to support my argument. The BEA (finally) revised its estimates for official inflows over this period. Guess what? The BEA now thinks that official inflows are a lot higher than they used to be.

Total inflows — according to the revised data — peaked at around $700 billion in third quarter of 2008. That fits what we know about global reserves far better than the unrevised data; the enormous increase in the pace of reserve growth dominated in change in the dollar’s share of total reserves. Studies that use the unrevised data — essentially any study that works off the monthly TIC data series — to argue that the fall in central bank inflows after 2004 had no impact on yields so central banks had no impact on the market need to be revised. It turns out that there really was no sustained fall off in central bank demand for US assets. The recent $700 billion peak easily exceeds the $400 billion 2004 peak.

A lot of ink has been spilled analyzing whether the recent crisis has reduced US global power. That framing though misses a key point, namely, that the pre-crisis world — one where the US relying ever more on a small set of governments to finance a large trade deficit — wasn’t exactly on a favorable trajectory for the United States.

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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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One. This was a very weak report. Very modest demand for US financial assets from the rest of the world is creating ongoing pressure for the US to adjust — that is for the US trade deficit to fall. Net TIC flows — counting short-term flows — were negative. And unlike in January and February, the negative flow wasn’t coming from large bank flows stemming from the repayment of the Fed’s swap lines (i.e. change in banks’ own dollar denominated liabilities per line 29). Private US purchases of foreign equities ($9.2 billion) exceed purchases of US equities by private investors abroad ($3.7 billion). Americans also bought $13.8 billion of foreign bonds, while — if purchases of Treasuries are set aside — private investors abroad were selling US bonds. That isn’t a good combination for a country with an ongoing trade deficit: Americans wanted to invest abroad more than the rest of the world wanted to invest in the US.

Two. Official investors are shifting out the yield curve — i.e. buying short-term notes rather than just buying short-term bills. The TIC data release shows that central banks bought $17.1 billion of longer-term Treasury notes while reducing their bill holdings by $12.1 billion. That implies a (modest) net $5 billion increase in central bank holdings of Treasuries.
But we also know that this is too low a figure. Central banks holdings of Treasuries at the New York Fed rose by $31.8 billion in April. And a familiar pattern reasserted itself in the data: large purchases of Treasury notes ($22.4 billion) by investors in the UK. A lot of those notes — based on past patterns – were then sold to central banks and then shifted over to the New York Fed. I would then estimate — based on the TIC data — that the real rise in official holdings of Treasuries is close to $27 billion, which fits the custodial data.

Three. The apparent fall in China’s holdings of Treasuries is sure to attract a lot of attention. China’s bill holdings fell by $14.79 billion, while its long-term Treasury purchases were only $10.33 billion. That seems to imply a $4 billion plus fall in China’s Treasury holdings. Looking at the ensemble of China’s US portfolio doesn’t change the picture. Total short-term holdings fell by $22.2 billion, more than offsetting China $7.6 billion in purchases of all US long-term assets (China sold Agencies and corp bonds).

I don’t buy it. This is a case where it helps to know the pattern of past revisions — especially the pattern of past revisions when oil prices have been low. In such periods, China tends to account for a very large share of purchases through the UK. In other words, some of the $22.4 billion of Treasury bonds initially sold to UK banks were then sold to China’s central bank. From mid-2006 to mid-2007, about 2/3s of the UK’s purchases of Treasuries were ultimately reassigned to China. I would expect the something similar is happening now — all of China’s bill holdings tend to appear in the US data in real time, but only a fraction of China’s long-term purchases tend to show up directly in the US data.

After adjusting for China’s purchases through the UK, I would guess that China’s total Treasury portfolio inched up in April. Consider the following graph, which shows the UK’s long-term holdings, China’s recorded Treasury holdings, and the Setser/ Pandey estimate for China’s true Treasury holdings.

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If you read the headlines earlier this week, you might well have concluded that the dollar’s days as the world’s leading reserve currency are numbered. Yu Yongding of China’s Academy of Social Sciences suggested that China should shift away from the dollar.* He isn’t alone. China’s population is no longer convinced that US Treasuries should be counted among the world’s safest asset.** Try feeding that into the Caballero, Farhi and Gourinchas model.***

On the other hand, if you ignore the headlines and just look at cold hard numbers, you likely would conclude that central bank demand for dollars has picked up — not slowed down. The Fed’s custodial holdings aren’t a perfect proxy for the growth in the world’s dollar reserves. Countries can hold their dollars elsewhere. But they are decent proxy — and data from the custodial accounts, unlike the IMF’s more comprehensive data, are available in close to real time. And over the last four weeks, central banks have added $71.36b to their custodial accounts at the Fed. Their Treasury holdings are up even more: $74.62b.

Those numbers, annualized, imply $900-1000 billion of demand for US financial assets — mostly Treasuries — from the world’s central banks. That isn’t a small number. It is close to half of the Treasury’s likely net issuance this year. It would go along way toward answering the question of who will absorb the expected increase in Treasury supply.

Last fall — and even in January — the rise in the Fed’s custodial accounts seemed to reflect funds that were being withdrawn from the international banking system. Not anymore. A host of indicators suggest that the banking system has stabilized. European banks aren’t scrambling for dollar financing. The Fed’s swap lines are shrinking. Bank stocks have rallied. And nearly every Asian economy that has reported its end-May reserves has reported a big increase. And it isn’t just that the dollar value of Asia’s euros and pounds has increased.

And with oil now back above $70 before global activity has rebounded (Mark Gongloff calls it a few form of decoupling: “decoupling” once described the hope that emerging markets could grow without developed markets. Now it could refer to commodities and economic fundamentals”) a host of oil-exporting economies are likely to start adding to their reserves as well.

Bretton Woods Two has come storming back. As Tim Duy notes, it increasingly looks like 2007 all over again.

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Simon Johnson poses the core question facing the United States and China well:

If [China] doubles [its] holdings of US dollar assets over the next couple of years (let’s say, going towards $4trn), effectively financing our budget and current account deficit, will we all end up safer or more vulnerable?

China currently has a bit over $1.5 trillion in dollar assets, as not all of its $2 trillion in reserves (and more like $2.3 trillion to $2.4 trillion in government assets abroad) are in dollars. About ½ of the total is result of China’s purchases in just two years, 2007 and 2008. China’s trade surplus isn’t shrinking, at least not in dollar terms. Lex’s argument that China’s surplus is waning can be challenged.* And even if China’s trade surplus stabilizes in dollar terms and shrinks relative to China’s GDP, China is on track to double its foreign assets – and its US holdings – over the next four years. Think a $350-400 billion annual increase in China’s dollar assets, and a $500b plus increase in China’s foreign assets.**

That prospect should scare China’s leaders. China’s population thinks China has already invested too much in low-yielding dollar assets. Doubling down only makes the problem bigger. Bridgewater’s Ray Dalio noted in February:

But they [China] own too much in the way of dollar-denominated assets to get out, and it isn’t clear exactly where they would go if they did get out. But they don’t have to buy more. They are not going to continue to want to double down.

Nor should the US want China to double down. The past few months have made it clear that China’s dollar problem can quickly become America’s problem, as China’s doubts about the safety of its US portfolio reverberate through various US markets.

To be clear, the basic risk China is running hasn’t changed all that much recently. China’s government fundamentally is overpaying for dollars (and euros) to hold the RMB down to help China’s exporters. That policy always has carried with it a high risk of future financial losses.

The current crisis hasn’t changed that basic reality.

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