Tuesday, December 30, 2008
the governments of china and japan are the only support
Both private capital inflows to the US and private capital outflows from the US have fallen sharply. They have gone from a peak of around 15% of US GDP to around zero in a remarkably short period of time …
This sharp fall has bearing on the bigger debate over the role global capital, global savings and foreign central banks played in helping to to create the conditions that allowed US households to sustain a large deficit for so long — and whether American and other policy makers should have paid more attention to the risks that came with the surge in foreign demand for US financial assets earlier this decade...
I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system [which has now reversed completely -- gm]. ...
Why didn’t the total collapse in private flows lead financing for the US current account deficit to dry up? That, after all, is what happened in places like Iceland — and Ukraine.
My explanation is pretty straightforward.
Central banks were the main source of financing for the US deficit all along. Setting Japan aside, the big current account surplus countries were all building up their official reserves and sovereign funds — and they were the key vector providing financing to the deficit countries.
in other words, most everything you've ever read or heard about foreign investor demand for "safe" and "liquid" dollar securities as a support of american borrowing habits is just so much horseshit, just nationalist propaganda and american conceit. only the mercantilist trade-protection currency management of the governments of china and japan (as well as petrodollar recycling from oil states) has ever really supported american national profligacy.
If and when China and Japan are no longer able to support the continued growth of US deficit financing, the dollar and the bonds will contract (decrease) in value, and perhaps precipitously, like a house of cards. It is much worse than we had imagined, and more concentrated on these two countries, along with Saudi Arabia, than we had thought.
For now the balance is maintained because of self-interest and fear. But we cannot stress enough the highly artificial nature of the arrangement, and its inherent instability, now that the charade of sustained private investment flow is shown for what it is. There is no economic theory to support this model other than a distorted form of neo-colonial parasitism.
This is why the world has not developed a sound replacement for the dollar hegemony. It is because if they do, they must navigate around the probability, not possibility, of a collapse of their dollar reserves, and a dislocation of their own export driven economies, much worse than we might have imagined. It is not a matter of economic inventiveness; it has become a matter of will.
Who will be the first to flinch? History shows it is rarely a conscious decision, but rather some incident, an accident, some trigger event, even one so small, that it creates astonishment at the size of the avalanche it unleashes.
To make it clear and simple, this is the first evidence we have seen to suggest that hyperinflation is in fact possible in the US. As you know, we have been strongly adverse to the extremes in outcomes, both in terms of a sustained deflation and a significant hyperinflation.
That has now changed. The dollar is a Ponzi scheme, the waters of debt are overflowing the dam of artificial support, and only a few countries, two of them somewhat unstable, are holding back the deluge.
i've suggested here that it is likely that china will maintain the renminbi peg to the dollar in an effort to protect its export sector and engage in what amounts to a competitive currency devaluation, shifting as much of the burden of excess capacity liquidation onto its trading partners as possible. now that it is facing a full-fledged deflationary collapse at home, the dollar-peg-transmitted inflation of the last year is no longer a worry.
this is what keynes would have decried as a maladjustment -- excess capacity is a chinese problem, whereas excess demand (more particularly its residue, excessive debt) is an american one. an appreciation of the renminbi would move china in the direction of ultimate adjustment, that of increased domestic demand and a slimmed-down export sector. but the frictional cost of that transition may well be greater than the chinese political system can tolerate -- and so the adjustment is being resisted, the excesses perpetuated as best as is possible.
but also consider: a continuation of vendor finance will make a market for the colossal wave of american treasury debt issuance that will shortly be hitting the street. to maintain its peg, china will be forced to buy as much as treasury will issue to prevent the fed from monetizing and weakening the dollar vis-a-vis the renminbi.
if china and japan give up the chase and step away from mercantilism, not only will they have to bear the brunt through a rising currency of the contraction of the greatest excess capacity problem in recorded history -- and, in china's case, falling into revolution and chaos as a potential or even probable consequence; they further risk seeing their primary export market implode its currency and fall into a hyperinflationary trap which annihilates its purchasing power, aggravating an already massive retooling of their export-driven economies.
in other words, they probably feel they must try to continue with mercantilism. as martin wolf noted, however, the result is likely to be the united states "spending itself into bankruptcy". some in japan are already offering alternatives to try to prevent a debt-issuance-fueled dollar collapse, but for now the inertial path seems to be a continuation of the global financial balance of terror.
UPDATE: as michael pettis pithily notes -- everybody is working hard to increase global trade imbalances.
The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.
This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.
there are tremendous assets (in a certain sense unimaginable, really) underlying the dollar, both material and pyschological. we tend not to appreciate the magnitude of these in an epoch of disillusion and despair --and that´s natural and probably even healthy, in the long run. but still.
gm, I´m still a bit confused as to why continued reliance on mercantilist ploys (in a millieu of vanishing external demand) necessarily means less "frictional cost" for China. it won´t work, for one, because the more China tries to shift the burden of over-capacity to the deficit countries the more those economies will rebel and the more the export market will shrivel. and aren´t there political advantages just as ripe and sumptuous for a regime of China´s type to be gained from giving folks at home cheap credit and encouraging them to buy things? you still produce, that´s the point. in fact, it´s the best (only?) way to maintain your production. you just redirect a larger chunk of what you produce to _yourselves_.
finally, in contemplating vendor finance endgame, wouldn´t debt forgiveness and such (hell, Japan´s already talking about it) seem a much more likely and self-interested resolution for everyone than dumping dollars willy-nilly or making some other mutually destructive move that could theoretically open the door to dollar hyperinflation?
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pressure is increasing in china for the appreciation of the yuan to accelerate. this would have the great intermediate-term benefit of moderating chinese inflation and cutting speculative inflows to the country, even though the transition could be disruptive. it is also the long term policy goal of the chinese government as they move to a free floating currency from a dollar peg, which will likely allow the yuan to become the de facto reserve currency of the far east (with all the implied benefits). as demonstrated by private research i've had the pleasure of reading, many highlight the potential cost to china -- particularly forex losses on its massive dollar-debt holdings -- but ignore the manifold benefits. a stronger yuan would reduce the cost of oil for china in local terms, and this benefit alone given the rate of oil consumption in china would all but offset all the forex losses. its export sector would be hampered on the lowest end, but china is already in the process of moving its manufacturing capacity up the scale of finished goods into more complicated products (such as cars and semiconductors) where there are simply no viable competitors in the world on quantity and price. the net cost to china of revaluation is widely overestimated in the united states -- largely out of wishful thinking, i suspect.
again, the hope is that a fall in oil prices thanks to demand destruction and clipped speculation would forestall the pressure to appreciate the yuan, at least out beyond the six months that merrill is speculating above. but for the united states, increasingly rapid yuan revaluation would almost certainly mean the end of the debt supercycle and vendor finance -- and would shift the current credit contraction into a much higher gear, as it would effectively remove from the field the primary creditor of both the american government and the GSEs. the kind of collapse that would come in america following a sudden yuan appreciation would be a life-changing event for all americans. it is going to happen in the not-so-distant future -- but i think we should universally hope that it doesn't this year or next.
but -- in spite of the eventuality of the move and the benefits china would see -- china is in reality neverhteless clearly making the policy choice to weaken the RMB.
i agree further with you that this policy choice only serves to INCREASE the overall damage wrought by the crisis, and in the end the damage to china proper -- it is in effect the chinese smoot-hawley act. it is beggar-thy-neighbor policy.
but within china -- allow me to speculate a moment -- maintaining the peg or even devaluing may be seen as a national response to incipient deflation, just as the united states sees its devaluation. much as the appreciation of the RMB was undertaken with a mind to mitigating the strong inflationary pressure being transmitted by american easy money before deleveraging began in earnest (remember july? lol -- things move fast!), depreciating it is the flip side of the coin. chinese leadership, if it even believes that a current account balance adjustment is necessary, may be gambling that american devotion to free market principles -- after all, we followed that ideology all the way into the trap as others behaved as mercantilists -- and fears of a depressionary global trade collapse will prevent america from sparking a trade war.
anyway, regardless of why, it is what they are doing -- and while i can think it shortsighted and risky and damaging and dangerous, i can also create effective rationalizations for the view that it is a necessary policy response: it has inertia, it is inflationary in a time of deflation, it is a trade relations gamble that could work given american proclivities -- and most of all, it may be the leadership's only real chance of staying in power and avoiding revolt.
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again to cite pettis: Can parochial concerns undermine the global adjustment? It has before.
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