from Follow the Money

What Geithner said. And then some

March 18, 2006

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Most of the blogosphere has already weighed in on Tim Geithner's most recent speech.   I am a bit late to the party.  

And I may not have much to add. I deeply agree with Geithner's argument that the foreign central banks, pursuing exchange rate targets, are building up their reserves and buying US bonds at a pace that lowers US long-term rates. 

Even with the broad shift globally to more flexible exchange rates, a substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets. The scale of this activity has been particularly dramatic in parts of Asia. The significant rise in the earnings of the energy exporters, many of whom also run exchange rate regimes that seek to shadow the dollar, has also generated a substantial rise in investments in U.S. assets. A large share of the capital flows to the United States that have financed our current account imbalance come from these official sources.

These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. ... we live in a world where major exchange rates do not move freely against the dollar ... [and] the dollar is not as flexible as we tend to think. ...  the effort to sustain these exchange rate regimes has required more expansionary monetary policy in those countries than would otherwise have been the case helps identify a substantial source of what market participants describe as very ample liquidity in world markets.

The size of this effect is difficult to estimate with confidence. The economies that are the source of these flows are in aggregate a substantial part of the world economy, and the collective flows from official sources are probably large enough to have some impact on U.S. interest rates. Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.

Geithner probably would put a slightly lower number on the impact of central bank purchases on US rates than I would, but that is a small difference.

Geither's argument that the absence of intervention by US policy makers is insufficient to generate real currency flexibility is an important one.   So is another argument he makes: central bank financing has masked the impact of the deterioration in the US fiscal position.

This phenomenon [official purchases of US financial assets] can act to mask or offset the effects of high levels of present and expected future government borrowing on interest rates, perhaps contributing to a false sense of reassurance that we can continue to run large structural deficits without risk of crowding out private investment and damaging future growth.

This masking is why I think the policy choices of China, Saudi Arabia and others are partly responsible for the US current account deficit.   Note the word partly.   Normally a big fiscal deterioration leads to higher interest rates, higher mortgage rates, less housing wealth and slower consumption growth.  But not in the US over the past five years. 

I would even go a bit further.   Central bank interventoin is doing more than just masking the real impact of the deterioration in the United States public finances.  It also is distorting a range of private investment decisions. 

An example.   The Wall Street Journal reported last Wednesday  that the "birth" rate for new factories in the US is falling:

"The death rate in manufacturing isn't any higher than it has ever been," says Daniel Meckstroth, chief economist at the Manufacturers Alliance/MAPI, an Arlington, Va., policy-research group that represents large manufacturers. "What's really changed is that the creation of new factories has dropped so dramatically."

The rate of factory openings was 3.8% in the third quarter of 1992 and stayed above 3% for much of the rest of that decade. But in 1998, the rate began falling and hit 2.4% in the first quarter of 2005. Closings, meanwhile, have hovered around 3.5% for much of that period.

This shift in industrial demographics is stirring concern about the long-term health of U.S. manufacturing. New factories not only create jobs, they also use cutting-edge technology, making them crucial to the nation's competitiveness. They are also vital to U.S. defense industries, with many of the most-advanced components and electronics made at newer facilities.

 (Hat tip Mark Thoma)

Yes, Mike Mandel, immigrants bring human capital to the U.S..    But immigration per se doesn't generate future export revenues.

Immigrants cannot work in factories that have not been built.    Turning the skills of immigrants into exports requires actually investing in the US export sector -- not just in the housing sector.   

At current exchange rates, it often doesn't make sense to invest in US factory rather a Chinese factory.   It may even make sense to source R and D in China rather than the US.  That is another form of masking.   The US won't be able to pay for its imports by exporting debt forever.  But right now, investing in US assets that will generate future exports doesn't pay.  So the US keeps itself is busy building and selling houses, rather than building factories to sell products to the world.   Or finding ways to use US labor to produce services that can be exported to the rest of the world.

Another example, this one from Keith Bradsher of the New York Times.  

Apparently, US auto firms are taking their most advanced automobile production technology to China.

This winter, Ford opened a second production line next door that is practically identical to one of its most advanced factories, the Saarlouis operation in southwestern Germany.

That doesn't make sense to me.   German labor costs are among the highest in the world.   $30 an hour?  Maybe more.  So firms operating in Germany have an incentive to substitute capital for labor. 

Chinese labor costs are among the lowest in the industrial world.  Maybe 60 cents an hour.  

So firms in China should have an incentive to substitute labor for capital.  Not to import German labor-saving technology!   

But - in large part because China has to keep domestic interest rates low to discourage speculation on the RMB - the cost of capital in China is very, very low.   So it makes sense to substitute capital for labor in China.  That to me is another form of distortion.  

And it helps to explain why China has had its own version of jobless growth.   

Full disclosure: I worked for Geithner at both the Treasury and the IMF.  My comments should be discounted appropriately.    But do read his speech, if you have not already.

More on:

United States

Budget, Debt, and Deficits