Round 1 has seen the world’s central banks picking up the slack from private investors and keeping the dollar afloat in the face unrelenting US current account deficits. Now we are hearing the first murmurs of Round 2, a coordinated move by some or all these same players to backstop crumbling US credit markets.
In very broad outlines, here is how Round 1 looks: Over the course the 1990s the US began to run increasingly large current account deficits, which then further swelled during the Bush years, peaking at nearly 7% of GDP in 2006 before falling back a percent or so.
Financing the deficit was not difficult during the go-go years of the ‘90s bull market, as private investment poured in from around the world. In the wake of the dot.com collapse of 2000-01, however, it became increasingly difficult to recycle dollars through private channels. Central banks, and to a lesser extent sovereign wealth funds, stepped forward to do the job. These entities now finance essentially the entire payments gap, largely by using their dollar accumulations to purchase US treasury bills. Acquisition of other assets, as when China tries to acquire an oil company or Dubai goes in for a money center bank, attracts headlines but as yet account for a small fraction of this recycling.
The willingness of these public entities (it may be a stretch to call funds under the control of Gulf monarchies “public”, but economic language is not especially nuanced) to hold dollar assets prevents the dollar from falling even faster, and more broadly, than it has and serves to keep US interest rates far lower than they would be otherwise. The growth in foreign dollar reserves alone last year was approximately $900B, in excess of the entire US financing requirement. It would be going too far to claim that this extraordinary level of support is motivated by a desire to sustain the US economy; certainly other interests are at play, but the effect has been to enable US consumption to exceed production by a substantial margin, year after year. Given the scale of the enterprise, you might call this not a bailout but an international payments sump pump.
Now we face a new crisis: because of large developing writedowns in the housing market and the opacity of investment instruments that bundled low-value mortgages in ostensibly high-value securities, a credit crunch is enveloping US markets. Banks and equity funds, desperate to safeguard what remains of their capital base, are pulling out of markets for a variety of loans: for business investment, for certain forms of municipal investment finance, for college students borrowing to pay tuition. This credit retrenchment, according to Larry Summers, constitutes “the most serious....economic and financial stresses that the US has faced in at least a generation, and possibly much longer.” (Thanks to Brad Setser for this.)
The Federal Reserve has created a term auction facility (TAF) which will extend up to $200B to banks, while accepting mortgage-backed securities as collateral. Effectively, this represents an infusion of $200B in demand for the most troubled assets. Dean Baker thinks this simply socializes the losses of the rich after years in which their profits were hoarded by an elite few. Even so, the biggest fear has been that the Fed intervention will prove to be too small relative to the size of the markets to make a difference. This is precisely Paul Krugman’s point, seconded by Setser. So does this mean that there is no defense against a financial meltdown?
Think again about where the financial clout now lies. After years of accumulating treasuries, foreign central banks now have a far larger stash of securities than the Fed. (The Fed’s holdings of treasuries stand at about $800B, less than a year’s accumulation abroad.) The Fed can play with its portfolio, selling some treasuries and effectively buying mortgages, but between them the dollar-soaked central banks of China, Japan, the Gulf states, Brazil et al. have an even larger portfolio to deal from. Hence the potential for these entities to step into the market and buy assets at risk.
Will this be Round 2? If it is true that the Fed is no longer big enough for the job, it’s hard to see an alternative. The US, even in financial tatters, is too big to fail, and it is not difficult to imagine that rescue discussions are already under way. It’s not a sure thing, but a coordinated global move could restore enough demand to keep mortgage and other bubbly assets afloat yet a few more quarters or even years into the future. This would buy more time for the adjustments needed to address the true underlying problem, massive ongoing US current account deficits. I could even imagine a quid pro quo in which support for US markets is tied to a set of policies to rebalance the US position, although it would not likely take a public or transparent form. (Whether those policies would actually do the job is another matter, of course.)
We are in highly speculative territory here, and I could be way off the mark. But maybe not, and if the second phase of the global bailout begins to take form in the next few weeks, tell everyone you heard it here first.