Wednesday, December 22, 2004

Asia and America's debt trap

Martin Wolf has a nice column on the current account situation in today's Financial Times. It seems all analysts more or less agree on the figures and what has to happen for a solution to emerge. I think Wolf is crazy to think that non-Japan Asia is going to soon run large current account deficits (become net importers of capital), although I agree it is desirable both for the world and for their future development. My comments are in bold below.

Asia could solve America's debt trap
Financial Times, December 22, 2004

Structural issues on all sides:

It takes two to tango. This has been one of the twin themes of my recent columns on global current account imbalances (November 24 and December 1 and 8). The huge deficits being run by the US are the mirror image of the surplus savings of the rest of the world. But the dance is becoming ever wilder. That has been my second theme. It is necessary to call a halt before serious injury occurs. The "blame game" among policymakers is idiotic: they have created the problem together and must solve it together.

There is no disagreement on the numbers:

...How difficult would the needed adjustments be? The first step towards an answer is deciding what a sustainable US current account deficit might be. In a recent column (FT, December 15), Raghuram Rajan, the chief economist of the International Monetary Fund, argues that the US could sustain a current account deficit of 3 per cent of gross domestic product (half the current level) indefinitely. Given US potential growth, net external liabilities would stabilise at 50 per cent of GDP, against roughly 30 per cent today. Given the chronic savings surplus of Japan and several other high-income countries, such deficits and liabilities seem reasonable for the world's biggest and most dynamic advanced economy.

...Now turn to the required changes in real exchange rates. To achieve a fall in the current account deficit, at full employment, of 3 per cent of GDP, the increased domestic supply - and reduced domestic demand - for tradeable goods and services in the US would amount to about an eighth of current output in this sector. Some analysts suggest that the needed overall real exchange rate adjustment could be close to 30 per cent from the peak three years ago. This would imply a further depreciation nearly as large as the one so far.

Bretton Woods II - eventually the EU caves in?

...As economists at Deutsche Bank have argued, a new informal dollar area has emerged that contains countries that either run fixed exchange rates against the dollar (notably China) or at least intervene heavily in foreign currency markets. This new dollar area contains over half the world economy. But it will also run an overall deficit of about $260bn (£133bn) in 2004. It is not surprising the dollar area's currencies have been declining against the rest.

As the pain grows, argues Deutsche Bank, the eurozone may also embark on foreign exchange interventions and so join the informal dollar area, even in the teeth of opposition from the European Central Bank. Most of the world would then be underwriting the US external (and domestic) financial deficits. That would be a nirvana for US policymakers in the short term. But it would also postpone - and exacerbate - needed adjustments.

Asia to the rescue? Not likely soon...

...The world will only dispense with its dependence on the accumulation of mountainous US liabilities if non-Japan Asia - above all, China - play the role to be expected of the world's fastest growing and most populous countries. Continent-sized countries should not go on playing the mercantilist game of piling up reserves indefinitely.

Non-Japan Asia needs to become a large net importer of capital. Aggregate current account deficits of at least $150bn a year, in today's prices, would be very helpful. Facilitating the emergence of the efficient capital markets and dynamic consumer demand needed for this is much the highest priority in global macroeconomic policy. Such reforms not only offer the only durable escape from the US debt trap. They are also exactly the changes Asia needs for its own long-term development.


Anonymous said...

Dollar's Fall Tests Nerve of Asia's Central Bankers

China, more than many countries, treats its foreign currency reserves as not just a way to control the value of its currency in international markets but also as a form of national savings. That is one reason its traders are encouraged to take greater risks in search of higher returns....

The guess is that should or when the time comes for a substantial change in the Yuan-dollar peg, the Chinese will use dollars reserves to invest directly in America. The Japanese appeared to do the same after 1985 and could do the same again. Curious.

Anonymous said...

U.S. Cutting Food Aid Aimed at Self-Sufficiency

WASHINGTON - In one of the first signs of the effects of the ever tightening federal budget, in the past two months the Bush administration has reduced its contributions to global food aid programs aimed at helping millions of people climb out of poverty.

With the budget deficit growing and President Bush promising to reduce spending, the administration has told representatives of several charities that it was unable to honor some earlier promises and would have money to pay for food only in emergency crises like that in Darfur, in western Sudan. The cutbacks, estimated by some charities at up to $100 million, come at a time when the number of hungry in the world is rising for the first time in years and all food programs are being stretched.


Anonymous said...

A close friend and several acquaintances from Nigeria repeatedly talk about China, and what they notice is the responsibility of leadership, which has been lacking in Nigeria, and an intellectual pride in China. For them, the wish is that a leadership tradition might develop to copy China's. Will China be successful? They are certain, as they wish.

Anonymous said...

Suppose that we had a 500 billion dollar claim on American assets, and that, even if the claim might be more were it in Euros, we were content to invest our dollars in American assets. Why should a increase in value of the Yuan, in time, be such a problem?

Anonymous said...

December 22, 2004

Brad DeLong:

I don't see any possibility of a severe crisis for the U.S. as long as our foreign debt is denominated in dollars or consists of equities. The dollar falls steeply, interest rates rise, the U.S. has a slowdown and (likely) a recession as eight million foreign-funded jobs in construction, investment, and consumer services vanish and the workers have to find new jobs in export and import-competing industries--but the big problems all all abroad. Foreigners and their central banks take huge capital losses on their dollar-denominated assets and find the U.S. market for their exports drying up. It's our currency, but it's their problem.

Let me put it this way: suppose foreign investors lose confidence in the dollar, and suppose that the Fed's reaction is, "Our monetary policy is to maintain internal balance: we are going to peg the dollar price of the 10-year Treasury bond at what we regard at an appropriate level." What happens then?

The dollar falls. The dollar falls until foreign investors think, "It's undervalued. It's so undervalued that 10-year Treasuries have got to be a good investment."

Are there any negative consequences to that fall in the dollar?

Yes--for foreign central banks that find that their dollar interest receipts on their reserve portfolios no longer cover the renminbi payments they owe on the debt they issued to buy their reserves. Yes--for foreign producers who find U.S. demand for their exports dropping like a stone. Yes--for U.S. workers who ship, distribute, and sell foreign-made products.

But the big domestic costs would come only should the Federal Reserve allow domestic interest rates to spike and keep them high. And why should the Fed allow that? Should the Fed raise interest rates to keep the value of the dollar from sinking too low? Should the Fed try to engineer a deeper recession to keep a one-time jump in the price level caused by higher dollar import prices from setting off an inflationary spiral? It's not clear to me it should. It's pretty clear to me it would not.

Thus, as I said, I see a problem for the U.S. economy--and a probable recession--but not a real crisis. Exorbitant Privilege carries the day...

IInterest rates are presumably staying low because lots of people think the break is still a ways away, and think they'll see it coming and be able to sell before the crunch.

If there were just one Asian central bank, it probably wouldn't ever dump the dollar. But there are at least four with huge positions. And then there are the European investors who hold dollar-denominated assets, who will one day decide that they would rather that Asian central banks were the ones bearing the risk of a dollar collapse...

Let's distinguish two cases:

(1) Foreigners decide to dump non-mature Treasuries. There is immediate downward pressure on the dollar, the yen, and the euro prices of Treasuries. The Fed decides to support the dollar price of Treasuries: it buys them for cash. The U.S. money supply goes up. The yen and euro prices of Treasuries collapse--hence the exchange rate collapses. But the U.S. still roughly maintains internal balance (or does the rising money stock ignite a wave of inflation?) And it seems to me the big problems are outside.

(2) Foreigners decide not to rollover mature Treasuries. The supply of dollars spikes on the foreign exchange markets, as foreigners take their dollars at maturity and run. The dollar collapses. The Treasury turns around and needs to find domestic buyers for its extraordinary new issues. The Fed steps in and buys a bunch of Treasuries to keep their prices from falling too much. The money stock rises, but rough internal balance is maintained... or is it?

The problem with me trying to think through both these stories is that I think them through assuming that financial markets are in rational-expectations equilibrium. Yet when I look around me I cannot believe that: the dollar is priced too high. The long-term Treasury bond is priced too high.


Anonymous said...

Nouriel Roubini:

Brad says that the risk in my scenario of a severe rollover crisis is small if our foreign debt is in our currency and is mostly equities. But, increasingly our foreign liabilities are not equities but rather debt and, increasingly, public debt (see for the BEA latest report on the US Net International Investment Position). In the 1990s our current account deficit was driven by a real investment boom and the capital inflow that was financing it was mostly foreign equities (FDI, M&A, greenfield investments). But since 2001, our current account deficit has worsned in spite of a fall in investment of 4% of GDP. Why? Our fiscal deficit with our public savings of 2.5% of GDP in 2000 turning into a fiscal deficit of 4% of GDP. So, for the last four years foreigners are financing our budget deficit and most of the increase in the net foreign liabilities of the US is debt, not equities and public debt especially.

By the end of 2003, foreign central banks held 1,472 billion of reserves (mostly US Treasuries), other foreigners held 542 billlion of US Treasuries and other foreigners held $1,852 of corporate bonds (a good chunk of which are GSEs, a semi-public for of debt). Thus, out of $ 9,633 billion of foreign liabilities over 2,000 billion are US Treasuries and almost another 2 trillion is corporate bonds. If you add other foreign debt of the US (liabilities of the banking system), only about 3 trillion of the US foreign liabilities are equity (FDI and equity portfolio). So, over two thirds of our foreign liabilities is now debt.

Thus, as i already agreed we do still borrow in our own currency (but for how long if we keep on debasing our currency?) while most of our foreign liabilities are now debt, not equity.

Also, in Brad's mild scenario the fall in the US $ should lead to a sharp increase in US interest rates; thus, both traded and non-traded sectors will be hurt by high rates, more so the non-traded but also the traded one. Thus, the ensuing recession will hit both traded and non-traded sector. In other terms, what would US growth be if long rates were now 6 or 7% rather than 4% once foreign central banks stop intervening to prop the value of the dollar?

Anonymous said...

Nouriel Roubini:

The Fed directly controls only short term interest rates and any action to stabilize long-term interest rates would be more than unorthodox, it would be an attempt to manipulate long term interest rates that, while not unheard of (Operation Twist in the US in te 1950s or Japanse purchases of long term bonds in the recent Japanese deflation) it would be highly unusual and not consistent with Greenspan philosophy (but Ben Bernanke may think otherwise as he considered such unorthodoxy in fighting deflation).

But let us assume the Fed does intervene to stabilize the long rate: domestic and foreign residents are dumping US Treasuries (both short and long) not because they want to hold dollar cash assets; it is because they are trying to flee a plunging dollar. Since the US does not have enough reserve to prevent the $ from collapsing, then the question is whether bond market intervention is a substitute to forex intervention to stop the free fall of the dollar.

My answer is not. First, intervening in the bond market is first of all an act of true desperation; it undermines confidence. Second, that action increases by massive amounts the monetary base in the US; it could more than double it or triple it overnite. Third, in a situation in which investors are trying to flee US assets in a rollover crisis such increase in liquidity puts massive further pressure on the US dollar and since the US does not have the forex reserves to stop the dollar free fall, the dollar falls further and the flight from the bond market is further exacerbated leading to even further liquidity intervention to sustain a falling bond market. Then you get both a currency crack and a bond market crack...Again, the probability of such severe crisis scenarios are small and a nasty shock to the bond market is anyhow the pain that the economic idiots in Washington and the White House need to feel to reverse their tax cuts and give up on social security privatization. Thus, bond market intervention is neither helpful nor desirable.

I am not saying a severe crisis will occur with certaintly. I am saying that continuing reckless fiscal policies will make it highly likely and force a policy adjustment. That is what we need.


Anonymous said...

Nouriel Roubini:

The two "cases" described by Brad De Long, where the real effect of the dollar crash are dampened do not appear as realistic.

In Case 1, the Fed needs to intervene to support long Treasuries; apart from my previous critique of this, the ensuing collapse of the dollar driven by massive liquidity injection leads to sharply higher inflation and the need for the Fed to tighten short rates. Also, markets may test the willingness of this highly unorthodox Fed manuever to defend a particular long rate (that is causing a truly massive liquidity injections and sharply falling dollar that are both highly inflationary). And in this game of chicken the Fed gives up the defense of the long rate peg sooner rather than later.

In case 2, you got a debt rollover crisis on all maturing debt, be it short or long that is coming to maturity. The De Long solution is to fully monetize the whole stock of public debt that is maturing and the one that would otherwise finance the budget deficit. Then, we are talking of liquidity injection (increase in monetary base) of over $1,000 billion in 2005 and much more if the crisis occurs in 20056 or later. Then, base money is liteally exploding (tripling, quadrupling or more), the dollar is then in real free fall and inflation goes through the roof.

Note that in all these scenarios you get not just a dollar crash (as you get a currency run and a bond market crash but also a stock market crash as in 1987.

In fact, as very intelligently pointed out by Billmon in a reply to my blog posting:

"It seems to me the events of the summer and fall of 1987 provide at least a partial precedent for the kind of rollover crisis Dr. Roubini is describing. The short-term failure of the Louvre agreement to stablize the dollar, plus an abrupt perk-up in U.S. leading inflation indicators led to a fairly massive exodus of Japanese institutional investors from Treasury debt, albeit longer-dated maturies, not T-Bills.(If you look at the Treasury Dept's chart referenced in the post, you can see the abrupt downward spike in average maturity that this produced.)

The end result, of course, was a rip-roaring bond bear market, a stock market crash, an emergency injection of liquidity by the Fed, and - depending on whose memoirs you believe - something close to a global financial crisis in the winter of 1988.

On the other hand, 1987 was in the rosy dawn of our new world order of massive U.S. financial imbalances - domestic savings rates were higher, debt loads lower. And, as Dr. Roubini points out, the Treasury had not yet transformed itself into the modern-day version of the Weimer Republic's Reichsbank. So in the end, the Fed was able to engineer a soft landing, kind of, sort of.

Alas, now we're two decades older, and a hell of a lot more leveraged. Presumably, a good old fashioned run on the T-Bill market would be infinitely more spectacular than the '87 crisis.(If nothing else, the effect on the monetary aggregates would be truly volcanic.) But if you were alive and sentient back then, and you remember what the world looked like on the evening of October 19, 1987, then you've got some idea what's in store."

So, we get a triple whammy ( a dollar crash, a bond market rout and a 1987 style stock market crash...Of course, every other risky asset collapses in this scenario as pointed out by my co-author Brad Setser: Housing collapses, corporate spreads go through the roof, emerging market debt collapse and every other risky asset under the sun....

Then, we will have to sell our Treasures rather than our Treasuries as discussed in another recent blog posting of mine (

Sounds too gloomy? In 1987 our fundamentals were much sounder than today both in flow and stock, this time around "the harder they will fall"...


Anonymous said...

Simply to be annoyed. That we are cutting agricultural development assistance to Africa bothers me deeply since agricultural development in Africa is tied so closely with long term conflict, and because we have an obligation for such assistance and do too darn little. Grumble.


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