from Follow the Money

Good thing Michael Mandel read my 2004 paper, not my 2005 paper -

March 27, 2006

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With the 2004 paper on US external sustainability, there is at least some possibility that Nouriel's and my dire forecasts will prove to be right.   The core argument of that paper is that the continued expansion of the US trade deficit is inconsistent with long-term US external sustainability, that the world's capacity to finance US deficits is not unlimited and the US trade deficit will start to shrink before 2008.  Note, trade deficit, not current account deficit - the current account deficit will remain high even as the trade deficit shrinks because of rising net interest payments.   

The first two arguments are not controversial among mainstream international economists.  The only real debate is over the timing of the adjustment - that is where Nouriel and I went out on a bit of limb. 

There is a much smaller chance (some might say almost no chance) that the most provocative argument of the February 2005 paper - that the Bretton Woods two system of central bank financing could collapse before the end of 2006 - will prove true.   We did not say that Bretton Woods two would definitely collapse by the end of 2006, but we certainly argued that the risks were not negligible.     So if it lasts through 2006, we will be wrong in part.  And if lasts in its current form through 2008, we will be wrong, period.  

We clearly argued that the risks of a disruptive adjustment were far higher than most thought, because the Bretton Woods two is structurally unstable.  Bretton Woods two really got started in a big way in 2003, when central bank reserve accumulation exceeded $500b for the first time.   Central bank reserve accumulation has now exceeded $500b for three years (03, 04, 05).   If that level of central bank reserve growth - actually a slightly higher level to match rising US deficits - lasts another three years, I'll concede that Bretton Woods two has proved to be far more stable than I ever thought.

I also have not tried to hide the fact that I got 2005 very wrong.  


As Michael Dooley has pointed out with some glee, the system of central bank financing of the US showed far more signs of stress in the fall of 2004 than in most of 2005.  Central banks added (by my estimates) around $670 billion to their foreign assets in 2005 (including all the foreign assets of the Saudi Monetary Authority) with far fewer complaints than in 2004.    I guess central banks like holding a rising dollar more than a falling dollar.   Rising US short-term interest rates helped keep central banks happy too -- in part because they kept private investors happy.  While total central bank reserve accumulation stayed at or above its 2004 level, central banks had to finance a smaller share of the US deficit in 2005 than they did in 2003 or 2004.

I would not say that the rise in the "tourist" dollar (the euro/ dollar) was the biggest thing I got wrong in 2005.   The "tourist" dollar gets a bit more attention than it should.  OK, the euro/ dollar doesn't just matter for tourists.  In many product areas, US firms compete against European firms for global sales (Airplanes for one. Big Turbines as well).  And the euro/ dollar clearly has a big impact on the valuation of US investment abroad.  But the core argument that Nouriel and I made in both 2004 and 2005 was not a dollar/ euro argument.   Remember, the dollar at that point had fallen by roughly 40% against the euro (and even now, it the fall from the dollar's peak back in 2001 is still close to 30%).   We argued that the dollar needed to fall against the currencies that matter for trade but had not adjusted at all or had not adjusted as much. 

Think the dollar/ RMB, the dollar/ yen and the dollar/ oil currencies.

So what do I think I got really wrong in 2005?

The dollar's rally v. the yen.   The yen didn't fall as much as the euro against the dollar in between 2002 and the end of 2004, and after its recent rally, it is now quite weak on a real effective basis (given ongoing inflation differentials).

The ease with which China sterilized $250 billion or so in reserve growth.   Interest rates on sterilization bills fell, as did inflation, despite faster (by my calculations) reserve growth.  Nothing like a bit of financial repression to create demand for low-yielding sterilization bills.

The willingness of the world's oil exporters to increase their holdings of dollars.   I would have thought that the Gulf states would be less willing than East Asia to hold dollars, for political not economic reasons.  Concrete data on this isn't very good, but it certainly seems like the oil states kept most of their savings in dollars.   The shift in reserve accumulation from Taiwan and Korea and Thailand and a bunch of other Asian countries (other than China) to Russia and the Middle East allowed those central banks who were more tired of financing the US (Korea for one) to get out of the game.

I also missed the continued rise in the private investors appetite for emerging market assets - but that is a topic for a different time.

In fairness, I should also point out one thing Nouriel and I got right: we argued that continued dollar pegs would produce a lot of political heat, and a lot of protectionist pressure.   That was before Schumer/ Graham.  Building protectionist pressures were not that hard to see.  Not all parts of the US have shared equally in the current boom.  Hell, some have flat-out lost - stagnant or falling nominal wages, rising gas prices and homes in shrinking flatland factory towns.  And many of the losers are located in "swing" (purple) states.   Think manufacturing workers in Ohio.

And in a lot of ways, some of the strains we expected in 2005 are showing in 2006.   Dubai Ports World didn't go down well with the Saudi central bank governor.   China is tired of receiving lectures from the US on how to run its economy, and is starting to fire back.    

Not many in the US have noticed, but the currencies of a few countries with large current account deficits have come under a bit of strain.  Iceland, obviously.   But also Australia and New Zealand.    All the high-carry small industrial countries.

That may auger something.   Or not.   We still don't know.   The world economy doesn't turn on the willingness of a few hedge funs to finance Iceland.

To answer Dr. Mandel's specific questions:

If the US trade deficit started to shrink in a nice orderly gradual manner without any disruptive moves in financial markets before 2008 in the absence of any coordinated policy changes I would be quite happy.   But any prediction registry would also say that my 2004 analysis was wrong. 

The tone of the 2004 paper - and the 2005 paper - clearly suggests that without some policy changes in the US and abroad, the process of adjustment, when it comes, is more likely to be disorderly than orderly.   Disorderly is over-used short-hand.  Concretely, it means significant falls in the dollar, higher interest rates, quite possibly some protectionist measures and US slump - not a smooth shift in the basis of US growth toward exports as the basis of the rest of the world's growth shifts toward domestic demand.

More generally, our 2005 paper clearly puts us in what might be called the "high interest rate" adjustment camp.   We emphasize an adjustment story that is prompted by a "foreign flight" rather than "consumer burnout" - the US doesn't cut back on its own so much as cut back because its credit line has run out.

Right now, I would put more emphasis on a modified version of that story, what might be called a "consumer burnout" gives rise to a "foreign flight" story.  

The plot would go more or less like this:

  • The US economy slows - housing, consumer burnout, all the standard bearish stuff.
  • The Fed cuts policy rates.
  • The dollar starts to fall against some of the other major currencies (euro, swiss franc) as short-term interest rate differentials shrink.
  • The dollar peggers have to step up their financing of the US - from an already substantial level - to push their currencies down against the euro as well.
  • And at some point, the dollar-peggers decide that they have had enough.   So they don't up their dollar purchases to offset falls in private demand for dollars assets and in the process provide the financing the US needs at the low rates it is accustomed to.

In 2005, central banks maybe provided $400b in net financing to the US (the $220b in the US data is too low given $650b in global reserve accumulation) and private investors $400.  With the US deficit rising, central banks might need to up their dollar financing to $700 or $800 or so should private demand for dollar assets falter.  

That may be a bit too much. Rather than follow the dollar down (again), China might suddenly rediscover its basket peg.  It China willing to increase its annual reserve accumulation to $400 b a year ($35b a month)?  

Without an increase in central bank support, long-term US rates may not fall even as the Fed cuts short-term rates ... Real US rates could well rise from current levels.   Those buying US bonds would want some compensation for risk of further falls in the dollar ...

Bottom line:

  • If central banks stopped adding to their reserves and that has no impact on the US economy/ long-term US rates, I think Nouriel and I will have been proven wrong.  So will Michael Dooley, Peter Garber and David Folkerts-Landau.   I don't worry too much about this though -  I find Bernanke's analysis of a savings glut more compelling than his argument that central bank purchases don't matter.
  • If neither central banks nor the markets force the US to adjust before the end of 2008, then I think Nouriel and I will have been proven wrong.   Absent any adjustment, I suspect the US is on course for a trade and transfers deficit of 8% of GDP in 2008 (it was 7% of GDP in q4 of 2005) and a current account deficit of over 9% of GDP and probably close to 10% of GDP in 2008 (rising net interest payments).
  • If the adjustment process is smooth in the absence of any policy actions, then I think Nouriel and I will have been proven wrong.
  • And if the adjustment process proves to be consistent with quite low nominal and real US interest rates, then I think Nouriel and I will have been proven wrong, and Joseph Gagnon (Paper), Steve Kamin (Paper) and their colleagues at the Fed's international staff will have been proven right.   And US creditors will take a bath - not just on the funds that they have lent to the US over the past few years, but also on the funds that they will still need to lend to finance ongoing US current account deficits in the future.

Remember, the US current account deficit isn't going away anytime soon - it is too big now, and it has too much momentum.   Barring a truly catastrophic crash, The US will need to borrow a lot of money from the world for a long-time to come - no adjustment, orderly adjustment or disorderly adjustment.

One last caveat: I am speaking for myself here; Nouriel may have a slightly different view of what constitutes success.

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