Global Imbalances « American Armageddon Judgement Day

Crazy World Order

This (somewhat dated) chart from the Economist sets forth in a nutshell the evolution of the world economy over the last fifteen years. Economists called this “Bretton Woods II.”

If you look closely enough, you can see the following: China and other emerging markets grew into export powerhouses. American corporations moved manufacturing “offshore.” To finance the purchases of foreign goods, Americans went into debt. Who lent us the money? By and large, the people who were sending us the goods.

The explosive growth of exports from China and the emergence of the US credit bubble were opposite sides of the same coin. Americans borrowed money to buy homes and saw them appreciate tremendously in value. Wall Street bought the mortgages, sliced and diced them, and sold them to foreign investors with a grade AAA seal of approval, courtesy of oblivious ratings agencies and undercapitalized insurers. Exporters bought the paper. In recent years, the United States sucked in 85% of the world’s savings. It turned out that Chinese peasants were speculating (they bought the paper courtesy of their central bank) in the wild manias of Miami, Phoenix, and Inland Empire real estate. (Until it started fleeing from agency debt, as it did in November 2008, China accounted for “about 50% of all central bank holdings of Agencies.”)

It wasn’t that complicated of an arrangement. The world sent us its goods; in return, we sent paper (really, electrons) bearing promises to pay in the future.

That arrangement is crashing.

10/25/08

Deficit on Current Account Contracting

At last count, the current account deficit increased to $183.1 billion (preliminary) in the second quarter of 2008 from $175.6 billion (revised) in the first quarter.

This chart, covering a five year rather than fifty year period, shows a broader contraction since 2006. Almost certainly it will continue to contract. For the debt to be paid, surpluses must be run. Will it be paid? Good question.

Our Best Friends: Foreign Central Banks

(click to enlarge)

Foreign central banks have added greatly to their holdings of Treasuries over the past 2 years. While this was going on, Brad Setser commented (April 14, 2007) that the world’s biggest current account deficit had been “financed almost exclusively by the official sector over the last two quarters.”

On this point, questions abound: Will the official sector continue to step up to the plate? Do they have any choice? Can government decisions arrest, mitigate, deny the broader pull of private capital?

Flight to Quality by Foreign Central Banks

So is there a difference in the US government guarantee of Treasury debt and “agency” debt–that is, the debt issued and guaranteed by Fannie Mae and Freddie Mac? Foreign central banks apparently think so; they have made a big change in their buying patterns over the past several weeks, as this chart from Brad Setser shows.

Setser explains the graph as follows: “Over the last 52 weeks, foreign central banks have added $321b to their Treasury holdings at the New York Fed (and no doubt more to other accounts) and $147b to their Agency holdings — for a total of $468b. And there clearly has been a big shift towards Treasuries recently. The rise in Treasury holdings over the last two weeks, annualized, tops $1 trillion. The fall in Agency holdings over that period (after the bailout of the Agencies), annualized, also tops $1 trillion.”

That is interesting. Foreign central bankers are not just thinking about the maintenance of their currencies; they are thinking about credit quality, just like private investors are doing.

10/16/08

The End of Bretton Woods II

The great imbalances had to end. Nothing like that could possibly go on forever, right?

It seems apparent that the arrival of “Peak Credit” will have profound implications for those imbalances and for the world economic disorder to come.

China stands to suffer as much, perhaps more, from this unraveling as the United States. Pity the creditor, who built up an enormous export industry directed to the American market, funded its ravenous appetites, and has now made the unpleasant discovery that his debtors are deadbeats.

We shall see what this means for Chinese exports, but the following older chart, incorporating data as of August 2006, shows how closely the growth of exports tracked the H-Share index of Chinese shares traded in Hong Kong.

Here’s a snapshot of another H-Share index as of October 17, 2008. It suggests that exports will follow share prices down.

The logical choice for China is a big domestic spending program, reworking its factories and investments to improving the standard of living of ordinary Chinese. A novel concept: make things for themselves rather than for us. They have gotten with the program in this regard.

This is not, in the first instance, “decoupling”—China will suffer greatly from the bust. But it does portend a new monetary system. As a “reserve currency” in the sense in which we have known it for a very long time, under the two Bretton Woods regimes, the dollar is kaput.

Though some believe that China’s appetite for US Treasury debt will not wane, there is a strong countervailing argument. Notes Ronald Solberg: “The concept of Bretton Woods II — wherein foreign investors were the lender of last resort extending vendor financing for their exports sold to the US (consumer) — was predicated on the stability of sustained household consumption. With the US household suffering from declining home prices, falling real wages, job loss and collapsing confidence, the American consumer will take years to recover their former spendthrift ways. With this missing critical link in the global relationship, it is suspect whether foreign governments will be willing to significantly increase their holdings of US dollar debt, if there is not the quid pro quo of increased export receipts from further US consumer spending.”

Russ Winter also sees the same dynamic: “The half trillion dollar domestic spending initiative from China has neutron bomb potential,” he wrote on November 10, 2008. “As Asia (and others) have the savings pools and currency reserves, this also means they have the capital to carry out their plans. I believe they are going to be ‘calling home’ monies previously lent to the US to do so, and will be MIA when future funding is asked for. Thus this could serve as THE Pearl Harbor moment for the US, and make the big bailouts and monster borrowing plans highly problematic without much higher interest rates.”

For background on “Bretton Woods II,” see the 2004 paper by Roubini and Setser and the update by Setser here.

Recall also that Japan had a 15% rate of domestic saving in the early 1990s after their bust; the government’s subsequent massive borrowing could be financed by Japanese households, whose purchases of government debt kept bond prices low. That is not the case with US households today.

11/29/08

Tuesday

The Linked Dangers Foretold (Sort Of)

Martin Wolf of the Financial Times writes:

“These linked dangers between external and internal imbalances, domestic debt accumulations and financial fragility were foretold by a number of analysts. Foremost among them was Wynne Godley of Cambridge university in his prescient work for the Levy Economics Institute of Bard College, which has laid particular stress on the work of the late Hyman Minsky.”

Brad DeLong has a different take:

“We—all of us from Nouriel Roubini to Lawrence Summers to John Taylor to Tim Geithner (except perhaps Ben Bernanke, who really did seem to believe in a long-run global savings glut)—were expecting a very different financial crisis. We were expecting the Balance of Financial Terror between Asia and America to collapse and produce chaos. We were expecting a free fall in the dollar’s value that would push and be pushed by large-scale capital flight from America that would produce high interest rates and a collapse of construction and investment. We were expecting a collapse of imports into the United States that would produce a free fall in employment and in political stability in Asia. We expected the Federal Reserve and the U.S. Treasury to be powerless—for we expected the safe asset that banks and investors would scramble for in the chaos to be anything but U.S. Treasuries and reserve deposits at the Fed. And for the avoidance of a catastrophic balancing-down of the world economy we expected the United States to have to depend on the kindness of, well, not strangers exactly but of a disorganized congerie of national Treasuries and central banks that were unused to a world without a Kindlebergian hegemon.

We are not having that financial crisis. And it looks like we will not have that financial crisis: if the past year’s financial chaos in New York has not provoked a run on the dollar, it is hard to envision a scenario that would. Instead we are having a very different financial crisis: catastrophic failures of risk management throughout the entire banking sector have caused a relatively minor—by the standards of the global economy—collapse in housing prices in Riverside County, CA, Dade County, FL, and a few other places to freeze up global finance to a degree that has not been seen since the Great Depression. The first good thing about this situation is that it does not call for different central banks and Treasuries to do different things, but rather for them all to do the same thing in unison without fouling each other’s oars.”

I see a couple of problems with DeLong’s analysis. One point is simply that those expectations may yet prove to be true. It isn’t over. The sharp rally of the dollar in the fall of 2008 was against the background of its previous sharp decline and reflected an “artificial dollar shortage.”

Not to be picky, but it’s also misleading to pair “catastrophic failures of risk management throughout the entire banking sector,” which undoubtedly existed, with a “relatively minor—by the standards of the global economy—collapse in housing prices in Riverside County, CA, Dade County, FL, and a few other places.” The US housing mania was just the tip of a vast iceberg of debt.

The unbalanced US debt/World equity ratio must put continued pressure on the dollar or bonds, and probably both. We are getting high interest rates on everything except Treasuries (an anomaly primarily to be understood as a reflection of panic into anything that doesn’t fluctuate by ten percent daily); we will almost certainly get a steep fall in domestic construction and investment. The resentment caused by the way in which dollar dependency has inflicted pain and suffering on others, even though the crisis originated in the United States, is a profound long term negative for the dollar’s status as a reserve currency.

The collapse of the American credit bubble will just as clearly lead to a crisis in Asian economies. The massive consumption fed by easy credit in the United States, with McMansions springing up in a distant wilderness accessible only by Hummers, is just the obverse of tens of thousands of Chinese factories geared to the western market. The deflation of the credit bubble here means bankruptcies and weakness there, a prospect that Asian bourses are clearly anticipating.

So I would say that we are getting that financial crisis, though via a route and with consequences that no one exactly foresaw.

This entry was posted on December 8, 2008 at 10:21 am and is filed under Blogroll . You can follow any responses to this entry through the RSS 2.0 feed Responses are currently closed, but you can trackback from your own site.