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Wednesday, December 03, 2008


2009: currency strains

the ft published a bit on economic nationalism today, citing BoA research.

the international community is shifting its focus from reserve accumulation to domestic economic stability.

Russia is liquidating accumulated reserve holdings (almost $150bn since August) to support its domestic economic/financial system while South Korean reserves have fallen by $50bn in a similar effort. China has pledged a massive fiscal stimulus (accounting details aside) in an effort to rejuvenate its domestic economy, reducing its level of aggregate savings that can flow into foreign markets. Even Brazil announced this week that it will potentially use part of its small sovereign wealth fund (SWF) to support its domestic economy.

Given this growing tide of “economic nationalism,” funding the U.S. internal and external deficits may become a source of legitimate concern for the USD entering the new year. And while it is early for these forces to unfold, there already has been a noticeable slowing in the rate of growth in custody holdings of Treasury and Agency securities at the Fed for foreign central banks and official institutions.

it is worth noting as brad setser did that domestic chinese stimulus cannot be financed from forex reserves. the danger here would instead be in a greater-than-anticipated china slowdown which would diminish their current account surplus.

but, in the best spirit of murphy's law, naturally this appears to be exactly what is happening, as long anticipated here. more attention is being paid now to china as playing a role clearly analogous to the united states in the 1930s as the "alpha creditor", with the united states now playing the role of the waning british empire. the sustained and yawning current account imbalance, now as then, is at the heart of many of our difficulties.

further, yves smith comments on a column by ft's martin wolf (which follows on an earlier column) on a misinterpretation of keynes that has run rampant in the developed world.

[W]hat is being advocated as a Keynesian remedy is in fact the opposite of what Keynes called for in his day. Keynes' prescription then would lead to a global rebalancing, with the US depending more on internally generated demand and less on its foreign partners (who were defaulting on their government debt). But if it were successfully deployed in the US now, it wold lead to a continuation, of our excessive consumption and China's underdevelopment of its internal demand.

that is, keynes wanted stimulus to abet international rebalancing to a sustainable situation, not stimulus to avoid that rebalancing. then wolf:

This is not a durable solution to the challenge of sustaining global demand. Sooner or later....willingness to absorb government paper and the liabilities of central banks will reach a limit. At that point crisis will come. To avoid that dire outcome the private sector of these economies must be able and willing to borrow; or the economy must be rebalanced, with stronger external balances as the counterpart of smaller domestic deficits. Given the overhang of private debt, the first outcome looks not so much unlikely as lethal. So it must be the latter.

In normal times, current account surpluses of countries that are either structurally mercantilist – that is, have a chronic excess of output over spending, like Germany and Japan – or follow mercantilist policies – that is, keep exchange rates down through huge foreign currency intervention, like China – are even useful. In a crisis of deficient demand, however, they are dangerously contractionary.

Countries with large external surpluses import demand from the rest of the world. In a deep recession, this is a “beggar-my-neighbour” policy. It makes impossible the necessary combination of global rebalancing with sustained aggregate demand. John Maynard Keynes argued just this when negotiating the post-second world war order.

In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

this possibility is particularly acute in britain, but in the longer term stands to determine outcomes in the dollar as well.

there is further the difficulty in assessing the potential for fiscal stimulus to actually render a benefit under these conditions. in a comment at paul krugman's blog, where the nobel-prize-winner further advocated the need for large fiscal stimulus in the united states, i wrote:

fiscal stimulus in the 1930s had the great advantage of only being tried following a titanic delevering of the financial system that ran for near four years from 3q1929 to 2q1933. previous to the completion of that process, in spite of unprecedented (though later overshadowed) monetary and fiscal efforts on the part of government, anything that stood in front of the train was mown down.

likewise in japan, what posen cites as the only effective episode of fiscal stimulus was seen in 1995 — some five years into the delevering which the government there had slowed dramatically through regulatory forbearance and other measures.

we can theorize all we like about the effect of fiscal stimulus, but no one (including even the most erudite and honorable economists) has ever run a benchtop experiment on this process. did the new deal reverse the great depression? or was it only possible to mitigate it in the aftermath of a huge systemic delevering?

that experiment can be run now to some extent, with systemic delevering only a year old. but early returns are not promising, given that the first stimulus package largely abetted household delevering and that all and sundry measures of quantitative easing have resulted in little more than huge bank reserves.

by attacking the delevering without triage and so early in the unwind, the keynesians may in their vigor not to be too late have actually ended up being too early. by not allowing delevering to sort the weak from the strong for us, surely much valuable support has been wasted on outfits that have no real hope of surviving (AIG springs to mind). that cannot be retrieved. moreover, to the extent that quantitative easing is attempting to support the whole pile of leverage now rather than reviving lending in the aftermath of a winnowing, even large doses will likely be less effective than smaller doses would be later on -- and this without diluting by perceived ineffectiveness the political will which must be assembled to back such measures.

the western world is clearly experiencing a deflationary systemic delevering that is likely still in its sprightly youth. banks and other financial institutions remain oversized and will be continuing to pare balance sheet; on the other side, consumers and corporates have belatedly grown debt-wary, reducing loan demand. the process of this huge adjustment will likely run for years, though it may not be this traumatic for the entire duration unbroken.

however, i continue to believe that we dismiss the example of iceland and perhaps soon great britain to our peril.

UPDATE: via cafe americain, the UN is joining a chorus.

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