from Follow the Money

Latest speech of FRBNY President Tim Geithner

January 15, 2005

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I pay a certain amount of attention to what New York Federal Reserve President Tim Geithner has to say just because he was my boss at the Treasury and the IMF (noted in the spirit of full blog disclosure). But he also has just about as much experience dealing with financial crises as anyone -- almost as much as Stan Fischer.

His most recent speech warns market participants and policy makers alike of the danger of not taking advantage of good times to build buffers and shock absorbers that can help cushion against unexpected risks. That is a lesson emerging economies learned the hard way.

But today, perhaps the biggest risk out there -- as Geithner notes -- is the risk that the market moves required to correct major macroeconomic imbalances (i.e. the US current account deficit) may be large and abrupt, not small and undisruptive.

In the financial markets, this broadly positive outlook has been accompanied by a dramatic reduction in risk premia, leaving the price of insurance unusually low against a less favorable or more volatile environment. These developments imply a view among market participants that future macroeconomic shocks will be more moderate than in the past and more likely to be absorbed without broader damage to economic performance or the financial system ... they imply that the imbalances in the global economy will be diffused smoothly

A bit further along Geithner notes:

This combination of fiscal sustainability problems, large external imbalances, and the tension in the existing exchange rate system creates the risk of unanticipated shocks to financial prices, even in a context where monetary policy credibility is strong. The probability of these shocks may be low, but it is higher than it has been, and higher than we should be comfortable with.

Like Delong, I would put more emphasis on "higher than we should be comfortable with" than on "may be low."

What steps does Geithner suggest to protect ourselves against this set of risks.

1) Take advantage of the "unusually low price" of insurance. After all, low prices can reflect an absence of sufficient demand for insurance.

Consider one example: the US Treasury. It could insure against a rollover crisis -- or against the more probable risk of significantly higher short-term interest rates -- by lengthening the average maturity of its new Treasury issuance. 4.2% nominal for ten years is not bad! But issuing ten year Treasury notes rather than two year or five year Treasury notes means slightly higher current borrowing costs. It also runs against the current de facto policy of keeping the supply of ten year notes tight to help keep the 10 year rate low ... See this Roubini post for all the gory details of recent US debt management.

Or consider the use of interest rate swaps by corporations who issue long-term fixed rate debt and then swap their long-term debt into short-term floating rate debt to save a bit of money -- and old Bill Gross concern relayed by the Capital Wire. This may note be as prevalent today: "curve flattening" (the reduced gap between short-term and long-term rates) should be making this kind of trade less attractive. But no doubt there are other examples out there.

2) Borrow less. Geithner warns: "the present fiscal trajectory entails an uncomfortable scale of borrowing and little insurance against possible adverse outcomes in an uncertain world." I presume the reference to Rubin’s In an Uncertain World will not be lost on many in the Bush Administration, nor will the implicit call for a Rubinesque policy of limiting US borrowing in good times, to better prepare for bad times. No disagreement here.

The US is on track -- using realistic assumptions -- to run ongoing fiscal deficits of around 3.5% of GDP even with steady, sustained growth, and thus has no fiscal "buffer" against worse than expected outcomes: an interest rate shock that increases the government’s borrowing cost, a recession that reduces tax revenues, a more expensive than expected war ...

One small point of disagreement. Geithner -- like most -- recognizes that current account deficits of 5-6% of GDP cannot be sustained indefinitely: the real debate right now is over how long those deficits can be sustained. Geithner, though, argues the flexibility of the US economy may allow a relatively painless adjustment (a Greenspan theme).

I am a bit less sanguine. The US has a fair bit of experience shifting resources (capital, labor) out of the production of tradable goods; much less experience shifting resources back into the production of tradable goods. Yet it is pretty clear that at some point, the US either has to export more, or it will have to import less -- and the required change is large in relation to the United States small export base (a key point made by Rogoff and Obstfeld, among others)

But even if labor can be redeployed quickly and easily into "tradables" production (Some people who left Ohio for Florida might need to move back!), there are limits to how fast the United States’ capital stock can change. Consider how our existing capital stock constrains our ability to adjust to a different kind of shock - an oil shock. To paraphrase Rummy, when an oil price shock hits, you are stuck with the car you have, not the car you might want to have. Even if you want to dump your H2 in the used car market and buy a Smart car, someone else has to buy the H2. The auto fleet turns over, but not overnight. Even if all new car buyers opt for itsy bitsy fuel-efficient cars, there will be lots of SUVs in the American fleet for some time.

Similarly, when the US finds it has to reduce its imports to match its exports, grow its exports to match its imports, or do some combination of the two, it will do so with the capital stock that is being created by investment decisions being made today. The US will go into an external adjustment with its current export sector, not the export sector it might want to have.

My worry? I don’t think there is much evidence that current low interest rates are spurring a wave of investment in US export industries, or in industries that compete with imports (deciding not to offshore something already done onshore doesn’t help to reduce the US import bill ... activities now done offshore need to be moved onshore).

Over the next five years, if you want a really big commercial airplane you won’t be able to by one from an American manufacturer. Or, more accurately, the American product will be somewhat smaller and based on a 1960s era design (admittedly, a great design, and one that has been updated several times). While Airbus is creating a brand new production line to expand its product range, Boeing is shutting down several of its older aircraft production lines, and the new line for the 7E7 is still some ways off.

Boeing-Airbus is just one example, and probably not the most typical, since Asia is not (yet?) a player in the commercial aircraft market.

More generally, though, the current pattern of investment is, in part, a byproduct of the distortions created by the Bretton Woods two system of central bank financing for US deficits. The implicit interest rate subsidy from Asian central banks spurs interest sensitive sectors, but Asia’s undervalued exchange rates discourages investment in sectors that currently compete with Asia, or will do so in the future. The result: plenty of investment in hard-to-export residential housing ...

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