- Blog Post
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Alan Greenspan’s comments on the US twin deficits are getting lots of play. Just saying that at some point foreign appetite for US assets is likely to diminish and won’t stay at its current strong pace is hardly news -- it is nothing other than a statement that US external debt cannot rise without bounds over time, and right now, US trade deficits far exceed those consistent with a stable debt to GDP ratio. But it is no doubt significant that Greenspan emphasized that "there are limits" on foreign appetite for US assets, not his standard argument that the "attractiveness of US assets" and "global portfolio diversification" could well support continued foreign demand for US assets for some time.
An aside -- the portfolio diversification has to be one-sided to fund the US current account deficit. If US demand for foreign assets goes up by more than foreign demand for US assets, "diversification" would lead to net outflows. To get net inflows, foreigners have to want to put more of their portfolio in the US and US residents have to (broadly) want to keep their portfolio in the US.
While I am glad Greenspan is lending his powerful voice to those calling for fiscal restraint to contribute to orderly adjustment of the current account deficit, the Wall Street Journal article this morning on Greenspan left me in a cranky mood.
I took his comment that government officials making "80,000-100,000" would be less likely to spot risky hedge fund activity (and, one assumes, risks of all kinds) than Wall Street experts earning millions rather personally -- afterall, at one time I worked for the US Treasury looking at emerging market risk. I would hope that the size of your salary is not always indicative of the quality of your analysis. Some people may be motivated by a sense of public service, not just a desire for private reward.
No one would argue that a green beret who leaves the US military and joins a private security contractor for five times the salary is suddenly five times more effective as a soldier. One of my colleagues left the Treasury to join the risk management team at a major investment bank. Did the quality of his work go up simply because he started to get paid more? Should the quality of something like the analysis of US external sustainability that Nouriel and I did be judged by our salaries (less, one assumes, that those on Wall Street doing similar work), or by our actual arguments? Indeed, I would argue that highly paid Wall Street risk assessment sometimes suffers from three problems:
1) The profit motive may hinder judgement of risks, especially if the profits are booked today and the risks are likely to show up later. Hence addmissions by bankers that their peers are "low-balling" credit standards to "gain lucrative trading income and gain market share" in today’s FT article on hedge funds.
2) Enormous reliance on risk management models that assume past correlations between different assets will hold true in the future. If Brazil and Russia moved together in the past, they will move together in the future. So it is OK to go long in Russia if you are short Brazil, etc. Works just until the correlations change.
3) An overreliance on contractual hedges. Take Russia in 98. Risk managers said it was OK to get the high yields in the Russian ruble T-bill market (so called GKOs) so long as you hedged your ruble devaluation risk. So hedge funds and I-bank prop desks bought dollar/ ruble hedges and said we are protected against a fall in the ruble, we have a contract that says we can by dollars for rubles at this price. The risk managers were satisfied. No one asked -- or asked hard enough -- whether the Russian banks selling dollars forward would be able to honor the contract if the ruble/ $ peg broke. A contract saying you can buy dollars is no good if the person who sold you the contract does not have any dollars when the contract comes due. That sometimes happens in bad states of the world.
Rather than looking at the financial system’s resilience in Argentina, Greenspan might want to look at the system’s lack of resilience after Russia’s default.