Those with doubts about the sustainability of the current US expansion (the doom and gloom caucus according to some) have long argued that there were two different scenarios that might give rise to a potentially nasty economic slowdown.
One scenario centers on what Tom Palley calls foreign flight. Nouriel and I put forward a variant of that argument back in 2005. We argued that there was a meaningful risk that neither private investors nor central banks would be willing to finance an expanding US current account deficit. Without the needed influx of funds, the US economy would slow, perhaps sharply. Interest rates – market ones – would rise. They would rise to the point where the US got the inflows it needed but the process would be messy.
Another scenario centers on what Palley called consumer burnout. The US consumer would no longer be willing (or perhaps no longer be able) to borrow to spend, so stagnant real wages would imply stagnant growth in consumption …
I think it is fair to state that the first scenario hasn’t materialized. The TIC data shows that foreigners bought over $1000 billion in US debt and equities over the past 12 months. The April and May inflows were a little on the weak side. $75b a month sounds like a lot, but it is only a $900b annual pace. But even $900b is a lot more demand for US debt than I would have expected a few years ago.
Nouriel’s current recession story (and DeLong’s worries/ Krugman's concerns) hinge on consumer burnout. Combined with inflationary pressures that keep the Fed from cutting and thus keep long-term rates higher than they have been and housing weaker than it has been …
Which brings me to oil.
I certainly didn’t anticipate it at the time, but in retrospect, high oil prices seem to have played a big role in warding off foreign flight. Oil companies are not the only folks out there budgeting for $25 a barrel oil. Most oil exporting-countries are too. Which means that they are building up their external assets like mad. (Continues)
SAMBA now estimates Saudi Arabia’s 2006 current account surplus will reach $115b; I think it might be bigger.
Russia’s current account surplus could well approach $120b as well.
Oil exporters will likely have a $500b current account surplus in 2006. That is a lot of money that has to be invested somewhere.
To top it off, Asia’s current account surplus hasn’t fallen in the face of higher oil prices. Largely because of China. Japan’s current account surplus has been constant. Lots of other Asian countries have smaller surpluses (or deficits). But China’s surplus is growing even as its oil import bill rises. Which means that Asia as a whole still has as big a savings surplus now as it had back in 2004.
The same surplus in Asia. A growing surplus in the oil exporters. That means a lot of cash that has to go somewhere.
I suspect a fair amount of the Gulf’s savings surplus – the GCC countries will have a current account surplus of over $200b this year – is in dollars. The GCC countries peg to the dollar even more tightly than China. And if it all goes to Europe (or the UK), it will just big up the euro (or the pound) and bid down European rates to the point where US assets start to become attractive to foreigners.
The huge oil savings surplus consequently has reduced the odds of “foreign flight.”
But it sure seems to have increased the risk of consumer burnout. Directly, since higher oil prices mean that consumers have less money to spend on other goods (unless they borrow more …). And indirectly, since oil is contributing to higher levels of inflation and higher than desired levels of inflation make it hard for the Fed to cut rates even if the US economy is slowing. And higher rates make it harder to sustain the housing boom. Oil thus contributes to all of Nouriel’s three ugly bears …
I don’t follow the US economy as closely as I try to follow the global flow of funds. And I certainly am not as willing as Nouriel is to call an inevitable US recession. But I think it is fair to argue that high oil prices – and oil exporters willingness to save almost all of the oil windfall – reduced the risk the US economy would slow because of “foreign flight,” but increased the risk of “consumer burnout.”
That at least is my current thinking. Which isn’t to say that oil is the only thing Nouriel and I got wrong back in early 2005. I at least think we underestimated China’s willingness to spend a ton of money to defend its peg. China’s reserves basically doubled – going from $500b to $1000b over the past two years.
To me, the interesting question remains whether strong consumer burnout eventually gives rise to foreign flight (or even domestic flight) as private investors start to think that the dollar will lose the support from higher interest rates than in Europe or Japan. And who knows, may be some central banks will follow the Bank of Italy’s lead and reduce their dollar holdings. Recently – as Stephen Jen notes – central banks have tended to do the opposite. They have tended to buy more dollars when the dollar was under pressure. They have bought dollars when others wouldn’t. If that were ever to change ..
But that is another topic.
One last point: the flow of funds from the Gulf to the US hasn’t gotten the same attention as the flow of funds from Asia to the US. In part, that is because this flow is well hidden. We know the Gulf has a huge surplus. But it is hard to find evidence in the US data of huge purchases of US assets by investors in the Middle East (though not hard to find evidence that lots of folks use London-based intermediaries to buy lots of US debt). I have spent a fair amount of time trying to figure out how various Gulf countries manage their funds.
And that job just got harder. Until the second quarter, most of the Saudi’s current account surplus showed up on the balance sheet of the Saudi Monetary Agency. The government basically deposited the dollars it gets from selling oil with the central bank, and the central bank increased both its deposits in the international banking system and its holdings of foreign securities. And it released data on its holdings. With a lag. But some data is still better than no data – and with the other Gulf countries, the rule is usually no data. They generally have taken the dollars they get from selling oil and given them to their oil investment funds, and the oil investment funds are rather secretive.
In the second quarter, though, something seems to have changed. About 2/3s of the Saudi’s current account surplus showed up in the central banks’ coffers in 2005 and in the first quarter of 2006. Brad Bourland of SAMBA wrote that the Saudis were getting about $17b a month from selling oil and $7b of that was showing up on SAMA’s balance sheet. That was the case in the first quarter. But not the second quarter. Only about $3b a month showed up in SAMA’s accounts. Saudi Arabia’s current account surplus was probably around $30b in the second quarter. But SAMA’s foreign assets only increased by about $10b.
Which means that there is a lot of Saudi money going somewhere.