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Alas, this list is rather long. There is a reason why Mike Dooley ended the first segment of our Econoblog debate by noting that he had been right (and I and other worry warts had been wrong) for 28 months. Make that 30 now.
In the paper I did with Dr. Roubini critiquing the stability of the Bretton Woods two system of central bank financing of US deficits, we predicted that the system would show signs of increasing strain in 2005, and perhaps crack in 2006. In reality, the system showed far more signs of stress at the end of 2004 than it did in most of 2005. Our paper lagged rather than led.
Going out on a limb has risks.
- US interest rates. I certainly did not expect the yield on the ten year bond to average 4.27 during the first 11 months of this year, almost exactly its average in 2004. Nor did I expect the yield curve to invert. At the end of 2004, the ten-year was somewhere between 4.2 and 4.3. Now it is somewhere between 4.3 and 4.4. But US short-term rates a bit higher now than back then. I continue to be astonished by the willingness of foreigners to buy long-term dollar denominated US bonds at current US interest rates in the face of a large (and still rising) US current account deficit. In both the first part of this decade and the first part of the 1980s, the US trade and current account deficit expanded. But right now, unlike in the 1980s, the US is not drawing money by offering a high interest rate on dollar bonds. At least not a high absolute rate.
- An interest rate differential that supports the dollar need not come from a rise in US interest rates. It also can come from falling rates abroad. If I could change one thing in the Bretton Woods 2 paper, I would put a bit more emphasis on non-US interest rates.
- The dollar/ euro. I did not expect the dollar to keep on falling v. the euro so much as for other countries to gradually catch up to the euro. But I also did not expect the dollar to appreciate against the euro. That reduced the gap between the dollar's depreciation against the euro since 2002 and the dollar's depreciation against key currencies in Asia and the emerging world. But it did so mostly by reducing the dollar's cumulative depreciation against the euro.
- The dollar/ yen. And the dollar/ Asia more generally.
- Risk spreads in emerging economies. They fell. Yet when Bailouts and Bail-ins came out, Nouriel and I argued that the combination of low interest rates, strong US and global growth and high commodity prices - ideal for emerging economies - was too good to last through 2005. We were wrong. Just look at the money that flooded into places like Turkey this year. Or read Mohammed El-Erian's PIMCO swan song. After the EMBI's (the index of dollar denominated emerging market bonds) great run in 2003-2004, I certainly did not expect the EMBI to deliver as strong a performance in 2005 as in 2004. See figure one in El-Erian's presentation.
- The impact of $60 a barrel oil on the US economy. Or more precisely, the lack of a bigger impact. See Martin Wolf. Higher oil was not such a surprise per se, but the absence of a larger drag from higher oil prices certainly was. I suspect the recycling of petro-profits into petro-dollars is a key factor supporting low US interest rates. And low US interest rates support the high valuations of many assets, not the least housing. Indirectly, then higher oil prices have helped to support the housing led US economy. Who would have guessed.
- Oil exporters' willingness to finance the US -- to join Bretton Woods 2, so to speak. Higher oil prices shifted much of the world's current account surplus from oil-importing Asia to oil exporting Russia and the Middle East. That allowed the weakest links in the Bretton Woods two system - the smaller Asian central banks - to get out of the business of financing the US. Korea, Thailand and India all saw their current account surpluses shrink and in some cases shift into deficit. the pace of their reserve accumulation also slowed dramatically. Conversely, the surpluses of the oil exporters absolutely exploded. To date, the oil exporters seem to be willing to lend the dollars they earn selling oil to the (oil intensive) economies in Asia back to the US, helping the US finance both its own oil imports and its imports from Asia.
- China's exchange rate regime. I read at least one set of tea leafs correctly, and did get the timing of China's shift to a basket peg more or less right. But even if I got the timing almost right, I got the magnitude of the change wrong. I expected a bigger move. And it turns out that China really did not make much of a change in its regime either. IDEA global calculated that China now pegs to a basket of 98% dollars, 1% yen and 1% euro with a small trend appreciation against the dollar. For an economist, the irony in a basket composed of 98% dollars is obvious. Let's agree to call it a dollar peg once again.
- The ease with which China has sterilized a $20 billion monthly reserve increase - a reserve buildup of well over 10% of China revised GDP. I thought that China would find it difficult to sterilize its (still very rapid) reserve buildup, and that these difficulties would spill over into faster than desired monetary growth, potential inflationary pressures and higher interest rates on sterilization bills. I was wrong. Strong deposit growth combined with administration curbs on lending left the Chinese banks very liquid, and they opted to buy PBoC bills for next to nothing rather than hold cash. Right now, there is not much evidence of inflationary pressures inside China. The slowdown in bank financed investment engineered by the PBoC during 2004 and early 2005 - perhaps aided by controls on some energy prices - seems to have worked. If anything, high saving/ low spending/ potentially over-built China may face the opposite set of pressures.
- The sharp fall off in recorded central bank support for the US. Think $200 billion in 2005 v $400 billion in 2004 (Or something like $300 billion in 2005 v. $500 billion in 2004, if you using the BIS's broader measure of central bank financing of the US) But on this, I dispute the data. I think the fall off in observed central bank support is more apparent than real. Central bank flows through offshore centers are being registered as private flows, and offshore dollar deposits from central banks are supporting other private flows.
Once all is said and done, I suspect that China will end up adding around $250 billion to its reserves. That includes the $15 billion transferred to a state bank, and an adjustment for the fall in the dollar value of China's euro and yen denominated reserves. And I would bet far more than 40% of those reserves are invested in dollars, even if only 40% of China's reserves show up in the US data.
Apart from China, though, the big chunks of cash are now to be found in the world's oil exporters. Russia and Saudi Arabia may end up with current account surpluses of around $100 billion each. All together, the current account surplus of the oil exporters will approach $400 billion. Collectively, they have more financial power than China. Russia's reserves are up by around $50b (they reached $174 billion just before Christmas). Russia also added something like $30 billion to its oil fund. The oil fund's assets reached $44 billion at the end of November, and are forecast to rise to $50 billion by the end of December. Russia also paid off $25b of its external debt (reducing its debt to the Paris Club by $16 billion in the third quarter alone). The assets of the Saudi Monetary authority are up by something like $60b as well, and private Saudis must be adding to their Swiss (and other) bank accounts as well. Who knows how much was added to the Kuwait and Abu Dhabi investment funds. I suspect that a large share of the assets of the oil states are held in dollars, even if the oil states growing dollar holdings sure cannot be found in the US data. I'll quote Mohsin Khan of the IMF, who ought to know: "While it is difficult to know precisely where these funds have been invested, a large chunk has likely gone into financial assets denominated in the US dollar. The rest is being invested in real assets and stock markets both in the West as well as in the region."
Of course, the core question is whether the US trade deficit will be closed smoothly, or whether the eventual adjustment will be abrupt. The rising US trade deficit certainly spanned a flurry of research at the Fed, the IMF and the IIE over the course of the year, with notably papers from Kamin, Croke and Leduc, Gagnon, Laxton and Milesi-Ferretti, Warnock and Warnock, Warnock and Freund and Truman. But I doubt all this work has settled the debate. The US external deficit - both the trade and the current account deficit - is still expanding.
There certainly wasn't a hard landing in 2005. But there wasn't a soft landing either. The forces piloting the world economy decided to let the US fly a bit higher -- and perhaps to make an already challenging approach a bit more more difficult.