from Follow the Money

Bretton Woods Two and Trade Politics

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The interest rate on the 10 year Treasury note is somewhere between 4.0-4.1% -- and the US seems to be having no trouble financing its current account (or its budget) deficit right now. The risk of hard landing remains just that, a risk -- right now the market hardly seems worried about the United States’ still growing external deficit.

Consequently, this is a reasonable time to step back and look back at some of the arguments that Nouriel and I laid out in February, when we put forward the case that growing external imbalances posed a growing risk to the US economy. We did not suggest that the hard landing was imminent -- we thought the risks were far higher in 2006 than in 2005. In 2006, the US external deficit would be bigger, one-off factors like the corporate tax holiday would have played themselves out, and Asian central banks would hold even more reserves than they do now -- calling into question their willingness to keep on adding to their holdings of dollars. But we did argue that the risks were more immediate than most thought.

Some of the arguments that we made in February look pretty good three and a half months later. Korea’s central bank governor has not mastered the art of communicating with the markets. But it is still pretty clear that Korea thinks it has all the reserves it needs and would rather not continue to add to its reserves. Japan is out of the market, but its past intervention seems to have left a legacy in the market -- the willingness of private Japanese investors to buy US debt hinges in part on expectations that the Japanese authorities will keep the yen from appreciating too much, and thus prevent dollar depreciation from wiping out the positive "carry" generated by higher US interest rates. Change those expectations, and US rates might change to compensate Japanese investors for the greater exchange rate risk. Above all, the burden that China has to bear to support the system seems to be rising. We don’t know the pace of China’s reserve accumulation in April or May, but I would not be surprised if both numbers turn out to be very high -- reserve accumulation of $30b, or even $40 b, in May is not out of the question. Annualized, that works out to $360 b (20% of GDP) or $480 b (25% of GDP) -- a phenomenal sum.

This was a key component of our argument: the burden China has to bear to support the system would rise, until it exceeded even China’s threshhold for pain - though the pain in this case is rather abstract. The pain comes from the growing gap between the coast and the interior and resulting social tensions from China’s unbalanced growth, future financial losses and difficulties keeping surging reserves from leading to a surge in the money supply. Jonathan Anderson of UBS estimates that China’s money supply should grow by about $70b a year, any reserve growth in excess of $70 b needs to be sterilized. If China’s reserves grew by $40 b in May (this is a pure guess), and 75% of those reserve were invested in dollars that provides $30 b of financing to the US. The US needs about $65-70 b in monthly financing to cover its current account deficit, so China’s central bank ALONE would be supplying just under 1/2 the needed financing.

China says it does not want to give in to US pressure -- though I would note it also did not move when the Bush Administration refrained from public pressure. But if China tries to "punish" the US for its public criticism by holding on to its peg, China, in effect, has to keep on financing the US at a low rate. Rather than kow-towing to US demands to change its currency, China will just keep writing large checks to buy low-yielding US securities ...

However, I think Nouriel and I did miss a couple of things in our Bretton Woods Two paper.

1) US assets could become more attractive relative to European assets if European interest rates fell sharply, not just if US interest rates rose. On the short-end, US rates have risen while European rates have stayed constant. On the long-end, US rates certainly have not risen (hence, the conundrum), but European rates have fallen. Bunds now yield 3.3% -- well below Treasuries.

2) China’s lending curbs could make it easier -- at least for a while -- for the PBoC to sterilize substantial reserve inflows by issuing sterilization bills that pay relatively little (perhaps less than China earns on its reserves). Chinese bank deposits are increasing rapidly, but the PBoC’s administrative controls have crimped the banks’ capacity to lend. The result: the banks use their spare cash to buy the PBoC’s sterilization bonds, and are willing to do so at a very lost cost. China has kept its deposit rate absurdly low to increase the profitability of the state banks, allowing the banks to write off some NPLs with ongoing profits (low deposit rates also helped keep lending rates low, and low lending rates and a growing economy make it pretty easy for firms to cover at least the interest on their loans, keeping NPLs low ... ). But as the banks buy more and more PBoC bills that yield about what they pay on deposits, their profits will fall -- relying on administrative controls to keep sterilization costs down has a price, even if that price is not immediately obvious. And as the pace of China’s reserve accumulation accelerates, that price will only grow.

However, our argument did not hinge entirely on the possibility that the world’s central banks would tire of financing the US, and slow the pace of their dollar reserve accumulation. The same imbalances that led to rapid central bank reserve accumulation were also generating growing strains on certain sectors of the US and European economies, strains that could easily be expected to give rise to protectionist pressure. That part of the argument certainly has been born out. There is a risk that the US will tire (at least politically) of Chinese imports before China tires of financing the US.

(Continues)This year, China is likely to import about $50 b -- maybe less -- of US goods, and $200b, maybe more, of US debt (assuming China’s reserves increase by $300b, and 2/3s of those reserves are invested in dollars). That is an unusual pattern of trade. I do not doubt for a second that many parts of the US benefit from this trade as well: the PBoC’s willingness to buy US debt -- treasuries, agencies, mortgage backed securities, even corporate bonds -- has helped the Fed support US consumption after the stock market bubble burst by generating a bit of real estate froth.

However, American who bought homes in San Diego (or all of California), Miami (and much of Florida), DC, New York, and elsewhere on the Eastern Seaboard generally don’t attribute the capital gain on their home to China’s willingness to finance the US, and thus to cover up the consequences of the US "savings" deficit. They certainly are not using their capital gains to write large checks to help out those losing jobs in the manufacturing sector. And remember, when a factory closes in a small town, the impact on town is profound: the small town usually is left with more houses than jobs, and that pushes down local real estate prices -- leaving those who lost their job with a smaller financial cushion from their "home equity" as well. Maytag employs 1/5 of the population of Newton Ohio, so shifting the Maytag plant to China would have a profound impact on the local real estate market (See the C1 story in the Wall Street Journal).

I think this raises a set of very real issues -- issues that go beyond the typical debate about trade liberalization. The underlying assumption behind most trade debates is that jobs lost in sectors that compete with imports will be offset in large part by new jobs in exporting sectors. The baseline assumption is that imports will be paid for by exports -- and there will be a shift from one "tradable" sector to another.

That does not seem to be what is happening now -- at least in the US. There is a shift out of sectors that compete with imports, particularly imports from China -- socks, washing machines, auto parts, furniture (the less glamorous parts of the US economy centered in the Midwest and the South) -- into the real estate sector, and other sectors sheltered from external competition. That is the consequence of balancing higher imports with more exports of "debt securities -- IOUs" rather than "goods and services."

As China’s global trade surplus rises, it is becoming clear that the US "savings deficit" (private as well as public) is matched by an equally large "consumption deficit" in China. As a result, the large US trade deficit is increasingly matched, now that China’s investment boom has cooled a bit, by a large Chinese trade surpluses (I am talking about both countries overall deficits and surpluses, not their bilateral deficit/ surplus). China’s is now big player in the world economy, despite still being a poor country: its goods exports (end 2004) were about 75% of US goods exports, and they are rising fast.

The emergence of large trade surpluses in one major part of the world economy -- and extremely large, sustained trade deficits in another big part of the world economy -- is, I suspect, a real challenge to the global trade regime. I "buy" John Gerald Ruggie’s "embedded liberalism" thesis. In the post-war period, trade liberalization was matched by a set of other policy changes that took some of the edge off creative destruction. Policies like social security and its equivalents in Europe, Europe’s public health care system, Japan’s system of lifetime employment and counter-cyclical macroeconomic policies to limit the business cycle.

One of the system’s unwritten norms, I would argue, was that the major players did not run current account deficits (or surpluses) or more than 5% of GDP. In the 1980s, the big battle between the US and Japan came when the US current account deficit was about 3% of GDP. Japan has run a sustained current account surplus for some time, but not a 5% of GDP surplus. Some resource exporters have run large current account surpluses, but not, I think, the world’s major manufacturing economies. With two major players the US and China now running deficits and surpluses on a scale that I suspect are unprecedented for major players in the world economy, it is no shock the global trading system is under a bit of strain.

You can argue that the traditional goods for goods trade left some potential gains from trade off the table, since it meant that savings short -- or investment rich -- countries were not generally running large external deficits, and importing large amounts of capital from abroad (though certainly no one anticipated that large gains from trade would come from the export of the savings of poor countries to rich countries). But the traditional goods for goods (or services for services) trade also simplified the external adjustment process -- growing imports were matched by growing exports, and growing employment in the export sector.

The current pattern of trade implies a large shift of resources out of the US tradables goods sector now (see this Business Week article), as the US runs up its external debt at an accelerating rate. But then -- probably within five and certainly within ten years -- the trend will have to reverse itself: there will need to be a large shift out of real estate and back into tradable goods production. No country can run large trade deficits for long without running up its external debt levels to levels that are difficult to sustain: on current trends, barring unanticipated valuation gains on US assets, the US external debt to GDP ratio will be well above 40% of GDP by 2008 -- a very high level relative to US exports.

My point: it is not surprising that the unprecedented US savings deficit and Chinese consumption deficit (and resulting US current account deficit that is now heading towards 7% of GDP and Chinese current account surplus that looks likely to exceed 7% of China’s 2005 GDP) is putting real strains on the trading system. Deficits and surpluses of this scale in major parts of the world economy challenge the norms of the post-war system -- and challenge domestic political compromises that enabled post-war trade liberalization. Even if deficits and surpluses of this size are economically sustainable, they may not be politically sustainable.

UPDATE: interesting DeLong riff that key’s off Krugman’s column. It touches on some of the themes discussed here, but in a shorter and punchier way ...

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