from Follow the Money

Read Rogoff and Reinhart

January 9, 2008

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Let me second Martin Wolf. Ken Rogoff and Carmen Reinhart’s recent paper is brilliant. They also have mastered the art of saying a lot in a little space. There is no excuse not to read it in full.

Rogoff and Reinhart compare the crisis in the US banking system -- and in the shadow banking system, which turned out to be rather linked to the real banking system -- triggered by the subprime crisis to other recent crises in advanced economies. They find "stunning qualitative and quantitative parallels across a number of standard financial crisis indicators."

Their figure 1 -- which plots the increase in real US housing prices against the increase in real housing prices that preceded other severe bank-centered financial crises in industrial economies (Spain in the 70s, Japan and the Scadanavian countries in the early 90s) -- is stunning. Rogoff and Reinhart note that "The United States looks like the archetypical crisis country, only more so" before concluding, in Rogoff and Reinhart conclude, in fairly Roubini-esque fashion, that:

"The United States should consider itself quite fortunate if its downturn ends up being a relative short and mild one."

In one somewhat surprising way, the US is in a better position than the other advanced economies that got into severe trouble: the recent increase in public debt was actually a bit smaller than the increase in other countries. The US current account deficit, by contrast, is much larger than in the other countries -- a source of concern, if the associated risks haven’t really been realized.

I particularly enjoyed the parallel they drew between today’s world and the world during the 1970s oil shock. They write:

"During the 1970s, the U.S. banking system stood as an intermediary between oil exporting surpluses and emerging market borrowers in Latin America and elsewhere. While much praised at the time, the 1970s petro-dollar recycling ultimately led to the 1980s debt crisis, which in turn placed enormous strain on the money center banks. It is true that this time, a large volume of petro-dollar are again flowing into the United States, but many emerging market economies have been running current account surpluses, lending rather than borrowing. Instead, a large chunk of money has effectively been recycled to a developing economy that exists within the United States own borders. Over a trillion dollars was channeled into the sub-prime mortgage market, which is comprised of the poorest and least credit worth[y] borrowers within the United States."

Clever. It also sounds right to me.

Two additional points are worth mentioning.

First, I suspect there is a real risk that the European banking system has been doing much the same thing as the US banking system, though on a smaller scale. An awful lot of money -- effectively recycled petroeuros along with Chine’s burgeoning euro reserves -- has been channeled through Europe’s banking system to the "poorest" borrowers within the European Union. Eastern Europe in particular. With luck, though, these borrowers will prove to be among the most credit-worthy borrowers in Europe, on the back of a convergence story. Eastern Europe is growing more rapidly than the rest of Europe. Nonetheless, a disruption in the internal recycling of external flows to the European Union remains a potential risk.

Second, emerging market central banks and sovereign funds have effectively "stood as an intermediary" between their own current account surpluses and capital flows to the US and Europe. Almost as importantly, they intermediated between private inflows into their own economy and the United States need for funds. Private capital is flowing into emerging Asian economies -- India as well as China. Private capital is also now flowing into the Gulf. The net outflow from these surplus regions comes entirely from the "official" sector. Dollars flowing into China and other emerging economies with surpluses are effectively transformed into demand for US bonds (And now US banks) by emerging market central banks.

The scale of this intermediation is even larger that the $1 trillion that flowed into the US subprime market. That is a cumulative sum. Emerging market central banks are adding over a trillion to their reserves a year.

The largely but not exclusively American "intermediaries" that took the credit risk associated with channeling petro-dollar and sino-dollar inflows into the "developing economy that exists within the United States own borders" are currently taking large losses. The emerging market financial intermediaries that channeled the oil savings surplus, the Chinese savings surplus and large private inflows to the US -- and to a lesser degree Europe -- are also likely to take losses. Not from credit risk but from currency risk. By and large, though, the currency losses have yet to be realized.

Once those losses are factored in, the total losses associated with the recent mis-allocation of global savings into US real estate are likely to be even bigger -- and a bit more dispersed than the credit losses.

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