from Follow the Money

Central banks, cheerleaders and paper losses

April 28, 2005

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This week’s Economist looks at the "paper" losses that central banks issuing local currency (or selling local currency debt) to buy foreign exchange reserves would incur in the event of the revaluation. Call me biased, but I think it covers ground that readers of this blog know well quite nicely.

Perhaps of greater interest is another Economist article, one that highlights concerns that the Federal Reserve -- or at least some Fed governors -- have been a bit too willing to downplay concerns about the US current account deficit. After all, a current account deficit of over 6% of GDP is, in Fed Vice-Chairman Ferguson’s words "now larger than it has ever been in our nation’s history." A current account deficit of this size in the world’s largest economy is unprecedented; we don’t know what sort of risks it brings with it. That ought to generate a bit of caution.

I cannot do better than to join the Economist in quoting Ted Truman:

Ted Truman, of the Institute for International Economics, who spent more than 20 years as director of the international finance division of the Fed, wrote recently that too many Fed officials are seen as "cheerleaders" for a smooth adjustment, rather than giving warning that the process might be unpleasant. "Overconfidence", he argued, "can undermine the credibility of monetary policy."

I certainly was amazed that Roger Ferguson gave a speech on the US current account deficit and hardly mentioned the fact that most of the 2003 and 2004 US current account deficit was financed by his fellow central bankers, not by the private markets. At least to me, that seems like germane information, and certainly something that needs to be factored in to any assessment of the current balance of risks.

The only reference I could find in Ferguson’s speech to the role of a set of investors who are not exactly flocking to the US for high returns was somewhat muted:

The East Asian economies that went through financial crises in the late 1990s have seen a plunge in their investment rates even as their saving rates have remained extremely high; the weakness in domestic demand has likely motivated the authorities in these countries to keep their exchange rates competitive to promote export-led growth, a strategy that has also contributed to the U.S. external deficit.

Asian central banks are going to take large losses on their existing holdings of dollar reserves; little can change that. The only thing in real doubt is the timing. But nothing guarantees that they will be willing to add to their losses -- by adding to their reserves -- indefinitely. Some might just listen to Mr. Pesek’s advice; you never know.

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