Wednesday, November 28, 2007

Uh Oh

This is serious:

The blue stuff is private sector financing of the US current account deficit; the red stuff is life support from foreign central banks and SIV’s (sovereign investment funds). Brad Setser points out, as he has from the beginning of his blog, that official flows (red) are greatly underestimated; by arithmetic logic they have to make up the difference between private flows and the current account.

But the point is clear: if the US were any other country (i.e. too big to fail), we would be in the grips of an economic crisis at this very moment. Foreign exchange would freeze up, essential goods would be unavailable, mass layoffs would ripple across the land, while the dollar would sink like a stone. This would be Mexico 1994, Argentina 2001.

But it’s not, at least not right now. By the grace of central bankers and oil fund managers we in the US get to sip our latte (or in my case Darjeeling) and muse on this question in tranquility. But the dollar keeps going down, and the governments that prop us up are taking really big losses. The talk now is of Wiley E. Coyote and Hyman Minsky.

OK, this is scary, but those of us who have followed the situation have been scared for years, and yet the crisis still hasn’t come. Maybe this is another false alarm. We have been in bailout mode for a long, long time.

Still, the risk of a rupture is real. My advice: progressive people need to start thinking systematically about the political environment we are likely to find ourselves in if all hell breaks loose. What narratives, based in reality or fantasy, will make sense of this catastrophe for the general public? Who will step forward to manage the crisis? How can we minimize the risk of an authoritarian surge?

And you think you’re paranoid?

18 comments: said...


This needs some further explanation. Are these net international capital account flows or what?


Sandwichman said...

Abu Dhabi to the rescue!

Peter Dorman said...

Sorry, Barkley -- I provided the link to Setser's detailed explanation, but maybe I owe EconoSpeak readers a bit more than that.

This graph shows capital flows that are:

net (inflows to the US minus outflows)

private (in the blue)

long term

portfolio (not FDI)

in 3-month rolling totals

As explained in Setser's blog, the flows pictured account for most of action on the capital account. (You don't finance a trade deficit with hot money, at least not for long, and FDI, with its level of commitment, is typically a small part of the total investment flow.)

Bruce Webb said...

Well my take on this like always is somewhat tunnel visioned. We don't have to simply assume that Social Security is going to achieve something closer to Low Cost than Intermediate Cost but it wouldn't hurt to start factoring the probabilities in. There is something like a two trillion dollar difference in projections for 2017 to 2027 between Low Cost and Intermediate Cost.

People have consciously and unconsciously priced in a reversal in flow of funds to Social Security in 2017 and a principal repayment starting in 2023 that may or may not happen. If we knew to a relatively certainty that a major bond buyer was prepared to step in in 2017 and buy between $150 billion and $200 billion for six years and maybe for decades past that would we still have the same worries about the current account deficit?

We have two economic models whose outcomes start to strongly diverge around 2012. One model currently points to shortfall in 2017 and depletion in 2041, the other points to shortfall in 2023 and depletion never. Under very plausible economic scenarios a principal balance now at $2.2 trillion might never have to be repaid, and only about 25% of the interest needing to be paid from General Fund cash.

In effect Low Cost would deliver us a multi-trillion dollar interest only loan with an effective interest rate of about 1.5%. It seems to me that this would throw our current expectations right out the window. Obviously I can't guarantee a Low Cost outcome or anything close to it but we are talking dollar swings that become significant within just the next five years and which get potentially huge in the ten years after that.

In other words our bridge-financing may be just around the corner, unseen by almost everyone but not by that fact any less real.

Low Cost is Out There. And long-term Social Security solvency changes everything from our view of sustainability of tax cuts to the risk of the Chinese starting to exit dollars. It is the Invisible Elephant in the Room and may even go a long way to explaining Dark Matter and recent yield curve inversions. Yet I can't get people who have the right mathematical tools interested in looking at this 'if and when' calculation.

I kind of feel Bones on Star Trek "Jim I am just a country Celticist not a ...."

Eleanor said...

I am having my usual trouble following? Could I have a simple explanation of what the graph means?

Anonymous said...

Question: Is this an explanation for what has happened or a lead indicator? The thing to notice is that this graph is not real time.

Specifically, foreign inflows fall off in September. This is about when the Dollar started a free fall against all major currencies. The point being: did the recent fall in the dollar fully or partially alleviate this sudden stop?

Anonymous said...

This kind of information is a bit obtuse for my level of understanding, but I think an article in today's NYT
relates to the issue. Everything of value is currently being bought up by the investment arms of a variety of foreign nations that enjoy a more plus oriented balance sheet. Blackstone Group, Citigroup, Carlyse Group, Bear Sterns, etc. Seems that mostly Arab principalities are doing the shopping.

The though occurs to me that if these Arab investment groups end up owning all the private investment banks will there be a significant change in US middle east policy, especially as it relates to Palestine/Israel? Or, maybe the Princes couldn't care less and will just enjoy owning most of the world's assets.

Peter Dorman said...

My apologies to readers who found this diagram, and my reaction to it, rather esoteric.

Without going into a whole disquisition on the balance of payments accounts, here is what's going on:

1. The US is running a very, very large trade deficit, 600-700 billion $US per year. This makes up the bulk of the current account deficit.

2. The current account deficit needs to be financed; i.e. the dollars have to come back to us one way or another. (There are no Scrooge McDucks lolling in their dollar/money bins overseas.)

3. In normal times this financing takes the form of foreigners using their dollars to buy financial assets in the US. In this way the heightened supply of dollars due to our imports (they send us goods, we send them dollars) is offset by a heightened demand (desire to buy treasuries and other assets in dollars).

4. If the financing falls short, this could take the form of downward pressure on the dollar. If it falls very short there can be a run on the dollar. A run on the dollar (or some other currency) is the form taken by international financial crises. For a grim account from the past, read Kindleberger's classic The World in Depression. It gets ugly fast.

5. Ever since the dotcom bust there has been a large gap between the US current account deficit and net inflows of finance. This difference has been made up by the willingness of foreign governments (central banks and sovereign investment funds) to prop up the dollar by buying and holding US financial assets.

6. The chart (finally we get to the point) shows that, in the most important category of finance (long term purchases of financial assets), there has been a complete collapse of private demand. Presumably the combination of continuing declines in the dollar plus greater default risk (subprime et al.) have spooked these guys. Now it is up to our buddies in Beijing, Riyadh etc. to finance the whole shebang. Properly measured, the red portion of the chart has to come in at $250 billion or so. That's a lot of red. Red = bailout.

We're getting by with a lot -- a lot -- of help from our friends. And the chart says we now have no other visible means of support.

I hope this makes the issue clearer.

Myrtle Blackwood said...

Well, it looks like the financial capital is flowing into the unregulated and opaque hedge funds instead of to the United States. (After all, noone else seems to have any money) ;-(

"The hedge fund jackpot for 25 people
In 2004, the average earnings were US$251 million
Total: US$6.275 bn
In 2005: US$363 million
Total: US$9.050 bn
In 2006: US$570 million
Total: US$14.250 bn
97 countries have a GDP above US$14bn,250 - 86 have a GDP of less than 14.250

Source: Alpha Magazine - Alpha uses two components to arrive at hedge fund managers’ earnings: the gains of their own capital in their funds and their share of their firm’s management and performance fees. Most funds charge a 5% management fee and a 44% performance fee)

The Financial Crisis Ten Years After
by Serge Berthier. Asian Affairs
ASEAN-ISIS Kuala Lumpur 2007 said...

Ah, now clearer, Peter. Of course the really big mystery for quite some time now has been why it is that we have this evermounting foreign net debt, both long term private (now not increasing apparently) and to foreign governments, that until now so far has not resulted in the investment income part of the current account turning sharply negative. This is usually the trigger for the really bad stuff in foreign debt crises in poorer countries, when they cannot service their debt payments from their export earnings. About two years ago there were all these people explaining this with these weirdo "dark matter" stories, and so forth, but all that tripe seems to have drifted away. Nevertheless, so far that investment income account part of the current account has not gone blooey negative yet. When it does, gag, that is when the you know what will really hit the you know what.


Myrtle Blackwood said...

I found this article whilst listening to Bob Dylan's 'Like a Rolling Stone'. It's probably not a coincidence?

‘Japan and China lead flight from the dollar’.
By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 12:26am BST 18/10/2007

How does it feel
How does it feel
To be on your own
With no direction home
Like a complete unknown
Like a rolling stone?

Princess on the steeple and all the pretty people
They're drinkin', thinkin' that they got it made
Exchanging all kinds of precious gifts and things
But you'd better lift your diamond ring, you'd better pawn it, la la


Eleanor said...

Thanks for the explanation. I'm finding this blog very useful and wonderfully sane and courteous. I say this, having just gotten myself tricked into a discussion with a troll on Angry Bear. I think the person was a troll, though -- due to lack of visuals -- I could not see his grey, lumpy skin and huge, long nose.

Does anyone have any idea what happens next? In the economy, I mean. I am finding the current situation kind of scary. said...


Nobody knows, and anybody who claims to know is just fooling people, including probably themselves. This is terra incognito, completely unlike anything ever seen in world history. The range of possibilities is simply enormous, and largely unappreciated and not understood by most people. While many amount to mild and gradual adjustments, there are indeed a number of pretty scary potential scenarios. For better or for worse, a lot of it will depend on behavior of the Chinese.


Bruce Webb said...

"In normal times this financing takes the form of foreigners using their dollars to buy financial assets in the US."

Well yes but the effect is not necessarily direct. The Chinese sell toys (and just about everything else) for dollars, which fact doesn't mean that they are buying US securities dollar for dollar. Instead they are using substantial amounts of those dollars to buy oil from Dubai and chromium from Africa which in turn may allow Dubai to buy a port in America or Africa to be able to import treated mosquito nets from the US.

The notion that trade deficits automatically equate to piling up of foreign reserves needs a little more
examination than it gets. Like us the Chinese are paying $98 a barrel for oil, those trade dollars are not always ending up where they start. Now if OPEC starts pricing oil in Euros we might have a problem, but a booming China or India have natural outlets for their current current account dollar.

'Buy Chinese toys! Make a Gulf Oil State rich!' said...

For what it is worth, I think the matter of which currency oil is officially priced in is not all that important, per se. It becomes important only if it leads leading OPEC members, such as Saudi Arabia, to shift reserves out of dollars into euros. But they can do that or not do that irrespective of what oil is officially priced in, which is a nominal issue. Indeed, the UAE and some of them are reportedly shifting out of dollars to euros already anyway.


Eleanor said...

Barkley -- Thanks for your reply to my question. I am trying to figure out an investment strategy for my old age, and so far the best I have come up with is crawl into bed and pull the covers over my head.

YouNotSneaky! said...

Well, one difference between US now and Mexico 1994 and Argentina 2001 (as well as pretty much any other financial/BOP crisis) is the exchange rate system - US floats, every other country that's ever experienced a run on its currency was on a fix.

I don't know if that's enough or to what extent it matters but surely it makes for a different situation.

Anonymous said...

In his article, Brad characterized what took place as 'a sudden stop', and in that sense yes very much like some of the 'developing' countries.

But then, as Barkley implies, there's so much more taking place. It may be worth considering, e.g., when, if ever, modern metropolitan banking systems have experienced such difficulties with the interbank markets.

From Bloomberg, 30/11/07:

"The ECB, the Bank of England and the Federal Reserve have all offered emergency funds this week to soothe concerns that credit conditions will deteriorate at the end of the year....

``Central banks don't have the tools to arrest this rise in Libor because the issue is no longer about liquidity, it's about credit concerns,'' said John Wraith, London-based head of U.K. interest-rate strategy at Royal Bank of Scotland Plc, the second-biggest U.K. bank. ``If banks aren't willing to lend to one another, there's nothing central banks can do.''

The gap between the rate on three-month interbank euro loans and the ECB's benchmark rate, which currently stands at 4 percent, is the highest since the central bank took charge of monetary policy in 1999....

Bank of England Governor Mervyn King said yesterday there's a risk a further drop in asset prices ``might impair the balance sheets of the banking system in the U.S., which would lead to a classic credit squeeze.''

King drew a distinction between the rise in credit costs in August and September, stemming from the plunge in the U.S. market for subprime mortgages, and the latest increase. He said the first round was driven by concerns about banks' liquidity and the latest by concerns about the health of their balance sheets."

Well, yes, and concern over 'subprime' holdings and a $12 billion run also drove "Florida's State Board of Administration, manager of the Local Government Investment Pool, [to halt] withdrawals yesterday". Smaller instances of same in Montana and a few other states.

We may not be Argentina but some similarites seem to be emerging.