from Follow the Money

The poor are financing the profligate

April 4, 2008

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Martin Wolf’s column – “The prudent will have to pay for the profligate” – focuses on the need for the broad public to help out some who took large risks in the boom, whether individuals who borrowed too much on the expectation that home prices only go up or lenders who lent to much on the assumptions that home prices will only go up so no doc/ no money down loans were safe.

Wolf notes that “In such predicaments, the government always emerges as the lender, borrower and spender of last resort”. US government specifically has emerged as the lender of last resort to both the world’s investment banks and to American households. Tim Geithner of the New York Fed made the case in his testimony today that investment banks now perform some of the functions of banks and also finance themselves by “borrowing short to lending long” and thus are exposed to market equivalent of a bank run. That provides the intellectual justification for the provision of Fed credit to investment banks even though their creditors are not small depositors. The FT reports that the US government – counting the Agencies as a de facto part of the US government thanks to the expectation that they are too big and too important to fail – is now the ultimate source of financing for most US home purchases (Scholtes of the FT: “Fannie, Freddie and the Federal Home Loan Banks, a network of bank co-operatives founded during the Great Depression, provided 90 per cent of the financing for new mortgages at the end of 2007”)

Of course, the various US agencies involved in housing finance are just intermediaries. They borrow the funds that they lend to US households in the market. And who supplies them – and for that matter – the US government with the financing it needs?

Other governments, in large part.

And generally governments in parts of the world that are far poorer than the United States. The very wealthy small Gulf states are the obvious exception.

Ergo, in Wolf’s terms, the world’s poor are financing the world’s profligate.

That was implicit in my lengthy (and rather technical) post on the IMF data on global reserve growth.

But it also shows up in the New York Fed’s data on the custodial holdings of foreign central banks. From that data we know that the world’s central banks added almost $70b ($69.8b) to their Treasury and Agency portfolios in the month of March alone (using the data from April 3 and March 6 data releases; the increase between the March 27 and the February 28 release would be a bit smaller – “only” $50b). That is a huge sum – almost $840b annualized. SAFE’s $2.8b purchase of Total is almost trivial by comparison.

The increase between January 3 and April 4 is only slightly less impressive -- $150.8b, or $600b annualized. And the Fed’s data usually understates central bank purchases.

I would go even further – and argue that the world’s poor are effectively subsidizing the world’s profligate.

PIMCO’s Bill Gross has argued that low short-term rates mean that a lot of savers are subsidizing various borrowers (and in particular financial intermediaries). He writes:

“Twelve months ago the yield on your money market fund was 5%+ but your next statement will probably feature something closer to 2%. Did your money market fund (which in aggregate approaches 3 trillion dollars) experience any capital gains in the process? Absolutely not. So it looks like your (the taxpayer’s) contribution to the bailout of banks, or Florida condominium speculators can at least be quantified: 3% foregone interest per year on whatever you own.”

His argument applies globally. Central banks are going to get a lot less interest income on their short-term dollar holdings this year.

Moreover, all central bank that bought a lot of dollars and held on to those dollars in 2003, 2004, 2005 or even 2006 has seen the international purchasing power of their dollars fall. Against Europe. And against commodities. Not requiring an interest premium on their lending to the US even though the US deficit (trade deficit that is) implied a high risk of dollar depreciation against other international assets is form of subsidy.

Indeed, some kind of subsidy may be intrinsic in the scale of central bank demand for “safe” US assets. Big purchases drive up the price and reduce the yield. That hurts the lender – and helps the borrower. And by keeping on buying (see the FRBNY custodial data) despite already buying enough to depress yields, central banks effectively choose to provide this subsidy.

Finally, those central banks that have been borrowing domestically to buy foreign assets in order to avoid currency appreciation will take large currency losses. Those losses could be considered a form of subsidy as well. China might well be financially better off if the CIC invested the funds it is raising domestically rather than externally. Choosing to buy depreciating external assets (to support an exchange rate policy) means choosing to take exchange rate losses. If China’s currency will eventually appreciate by 30% against both the euro and dollar, the $600b China is on track to invest abroad this year will generate a capital loss of around $200b – more than 5% of China’s GDP. That is real money for China and – on the assumption that China’s losses can be used to provide a rough guide to the “transfer” to the US – a real subsidy to various US borrowers.

There is a bit of controversy on whether a central bank’s exchange rate losses can be considered a subsidy. Many students of central banking (including Ted Truman, my former boss) emphasis that foreign exchange reserves have to be held abroad, and what matters is whether they maintain their external purchasing power – not whether they maintain their domestic purchasing power. It doesn’t even matter if those reserves were purchased by issuing domestic debt. A central bank can operate with negative capital – so its ability to perform its core domestic functions is not necessarily impaired by “book” losses from currency moves. The finance ministry doesn’t even necessarily have to write a check to the central bank to make up for its currency losses.

Fair points. But when a government is building up far more safe external assets than it needs rather than adopting policies that would increase domestic investment (issuing bonds to finance railway construction rather than the CIC) or raise domestic living standards (issuing bonds to finance more health care … ) it is reasonable to ask whether their external assets are a good investment. And for many poor countries, the answer is no – they are overpaying for foreign assets to hold their currencies down …

That is a choice. And it implies – I think – an ongoing subsidy from the taxpayers of many poor countries to borrowers in far wealthier countries …

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