from Follow the Money

Has the US outsourced creative thinking about external adjustment to … France?

September 16, 2005

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Many have noted that President Bush likes French-style vacations. 

Not so many have noticed that French economists have been at the forefront of thinking about the US current account deficit, and the external adjustment process.

Continues -- and even includes some (hopefully interesting) graphs that were made in the USA.

Helene Rey and Pierre-Olivier Gourinchas have done great work looking at the impact of "valuation changes" on the external adjustment process.  Such valuation changes matter for the US.    As by now most readers of this blog know, most US external debt is denominated in dollars, while a substantial share of US external assets are denominated in euro, pound and Canadian dollars (relatively little US investment abroad is in Asia and thus relatively little is denominated in the major Asian currencies; most US external investment remains in Europe).  Consequently, as the dollar falls against the major European currencies, the value of US external assets rises while the value of US external debt stays constant. 

That is a huge help, but - as Rey and Gourinchas note - it doesn't mean that the US can continue to run large trade deficits indefinitely.

Olivier Blanchard (along with Francesco Giavazzi and Filipa Sa, both European, but neither French ... ) has produced a clever model exploring the external adjustment process as well.  Blanchard, Giavazzi and Sa assume that portfolio preferences are fixed. US investors want to hold a certain share of their asset abroad and a certain share at home.  Foreign investors want to hold a certain share of their assets in their home countries and a certain share in the US.   These portfolio preferences are - in the model - independent of expected return.  US and foreign assets are imperfect substitutes, unlike in models based on Dornbush's assumption of perfect substitutability.    Interest rate parity does not need to hold.

Interestingly, the stock of US financial wealth is about equal to the stock of financial wealth outside the US.  But the US holds a lower share of its wealth abroad than foreign investors hold in the US.    At the end of 2003, Blanchard et al assume that Americans have about $35 trillion in assets, including roughly $8 trillion in foreign assets.  Foreigners are estimated to have $36 trillion in assets, including roughly 11 trillion in US assets (foreign central banks account for roughly $2.7 trillion of those assets).   Foreigners hold about 30% of their wealth in the US, while only a bit more than 20% of US wealth is held abroad ...

Blanchard et al argue that the large US current account deficit is a product of two things - a shift in US preferences toward foreign goods, and a shift in foreign preferences toward US assets.   In the late 90s, private investors abroad wanted US equities.  Today, the world's central banks want US debt.   The net result is a large current account deficit.  In the Blanchard/ Giavazzi/ Sa model suggests that the dollar does not need to depreciate all at once, it is theoretically possible to have a slow expected depreciation.   That is a bit different than in Dornbusch's model, where the dollar depreciates (a lot) today so it can appreciate (slowly) tomorrow.

Fortunately, the US has had the good sense to import these French economists - they all now teach in the US, even if at least a couple still spend their summer vacations in France.

More recently, Laure Frey and Gilles Moec of the Banque de France have produced empirical estimates of the impact of central bank intervention on US treasury yields that suggest foreign central banks have had a far bigger impact on the treasury market -- 140 bp in 2004 -- than the Fed thinks

Enough with models. 

Consider the following graph.  It shows that almost all the net increase in the Treasury stock (the blue line) in 2003 and 2004 was absorbed by foreign investors (the red line). 

The data on the increase in foreign holdings comes from the "flow data" provided by the BEA, and the change in Treasury stock is net of the Fed's holdings and comes from the Treasury Bulletin. 

It is also clear that foreign central banks account for the lion's share of the increase in foreign demand for Treasuries in 2003 and 2004.   The following graph shows "recorded" central bank demand for Treasuries (in red) alongside the increase in Treasury stock (in blue).  Remember, some observers think the US data understates the total purchases of foreign central banks.

To me, the estimates from the Banque de France seem more consistent with the actual scale of central bank purchases in 2003 and 2004 than the Fed's estimates. 

But there is one problem with the "central bank bid has kept Treasury yields down" theory.  Recorded central bank demand for Treasuries fell off a cliff in 2005, but - as we all know, Treasury yields have not soared.   The fall off in central bank demand in q1 of 2005 did lead Treasury yields to widen.  Remember the ten year flirted with 4.5 in March.  But the Treasury yields subsequently have fallen back, and right now, ten-year treasuries yield only a bit more than 4%.   And I am pretty sure the q2 data will show a very small increase in central bank holdings of treasuries -- central bank purchases of Treasury notes seem largely to have been offset by a fall in their holdings of bills.

The fall off in central bank demand is far more pronounced if you look at quarterly data, not the rolling annual total.   Consider this graph, which shows the quarterly increase in the stock of treasuries in the market (blue) and the increase in central bank holdings of treasuries.

What happened this year?   It is a good question, and one I'll explore in another post.   One hint though. While central bank demand for Treasuries has fallen (judging from the US data), central bank reserve accumulation has not.    Those funds have to go somewhere. 

I'll end with one last graph.  It shows annual reserve accumulation.  The basic data comes from the IMF, but I have estimated q2 2005 reserve growth using the numbers reported by the world's central banks, and adjusted the numbers to reflect the valuation gains central banks enjoyed on their euro holdings in 2003 and 2004, and their losses on these holdings in the first half of 2005.     The blue bar is the rolling sum of global reserve accumulation in the past four quarters, the red bar is the rolling sum of "official" inflows into the Treasury market recorded in the US data.




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