Ah, when it rains, it pours, We Americans get news that the US federal deficits are over the trillion mark even before Obama and Congress pull out the checkbook in an effort to buy some prosperity, when we also are told, via the New York Times, that China, our biggest creditor provider, is likely to be far less generous as far as buying our paper is concerned.
The Times does not make clear how sudden a reversal of conventional wisdom this is. Even though we have been of the school that the contraction in China will be worse than generally expected, most commentators, including experts we respect, have been swayed by reports from international agencies that frankly, are not willing to annoy the Chinese by saying their growth forecasts were delusional.
For instance, Brad Setser, who we particularly like because he is rigorous and digs into data, was nevertheless taken, in both senses of the word, by the World Bank’s latest World Bank report on China (issued late November):
Make sure it is the latest World Bank China Quarterly.
David Dollar, Louis Kuijs and their colleagues have outdone themselves – and in the process provided a clear assessment of the sources of China’s current slowdown and the risks that lie ahead. I won’t try to summarize the entire report. Read it. The whole thing. No summary can do it justice….
6. The last thing anyone needs to worry about is fall in Chinese demand for US treasuries.
The Treasury market obviously isn’t worried – not it 10 year Treasury yields are under 3%. And there is little reason for the bond market to be worried if current trends continue.
The World Bank forecasts that China’s current account surplus will RISE not fall in 2009, going from an estimated $385 billion to $425 billion. How is that possible if real imports are forecast to grow faster than real exports? Easy – the terms of trade moved in China’s favor. The price of the raw materials China imports will fall faster than the value of China’s exports. China’s oil and iron bill will fall dramatically.
In macroeconomic terms, China’s fiscal stimulus will offset a fall in domestic investment leaving China’s current account (i.e. savings) surplus unchanged. The 2009 surplus is expected to be roughly the same share of China’s GDP (9%) as the 2008 surplus.
In dollar terms, the World Bank forecasts that China will add almost as much to its reserves in 2009 than in 2008. That is a bit misleading: the 2008 reserve growth number leaves out the funds shifted to the CIC (ballpark, $100b in 08) and the rise in the foreign exchange reserve requirement of the state banks (ballpark, another $100b). But it captures a basic truth. Even if a fall in hot money inflows means that China will be adding $500b rather than $700b to its foreign assets, its foreign assets will still be growing incredibly rapidly. China already has – counting its hidden reserves – well over a $2 trillion. It is now rapidly heading for $3 trillion.
Yves here. When I read the Setser’s summary (I did skim the report, and it did not make a strong impression on me), I simply did not buy it. I also worried that I was being a reflexive skeptic and refusing to consider fresh data. Nevertheless, the idea that China would keep showing massive FX growth, on the same level as an eye-popping 2008, when world trade was falling off a cliff and hot money certainly no longer coming in on its face seemed ridiculous.
And a mere month later (and remember, the slowdown in China only started to get serious headway in September) a senior Chinese official, Cai Qiusheng, said that China’s FX reserves has ALREADY fallen by an undisclosed amount. So much for the race to three trillion. Oh, and he said reserves are below $1.9 trillion.
Separate and apart from China’s changing fortunes, the continued purchase of US debt was becoming controversial in bureaucratic and popular circles. The tone increasingly was that China had been snookered into buying lousy US paper. And since the regime had depended on continued growth to maintain legitimacy and social cohesion, the officialdom will need to find scapegoats for the downturn. Regardless of where one thinks the truth really lies, it’s a no-brainer that the US will become a leading culprit.
One remarkable omission in the piece is the failure to mention that the massive FX reserves resulted from China running first a hard, and then a dirty peg against the dollar. And correspondingly, there is no consideration of why China no longer needs to be as active to keep the yuan (which now appears to be back to a hard peg) where China wants it to be. A presumably smaller current account surplus and a capital exodus would seem to be prime suspects.
From the New York Times:
China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.
The declining Chinese appetite for United States debt, apparent in a series of hints from Chinese policy makers over the last two weeks, with official statistics due for release in the next few days, comes at an inconvenient time…
Beijing is seeking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to local governments to build new roads and other projects.
“All the key drivers of China’s Treasury purchases are disappearing — there’s a waning appetite for dollars and a waning appetite for Treasuries, and that complicates the outlook for interest rates,” said Ben Simpfendorfer, an economist in the Hong Kong office of the Royal Bank of Scotland.
Fitch Ratings, the credit rating agency, forecasts that China’s foreign reserves will increase by $177 billion this year — a large number, but down sharply from an estimated $415 billion last year…
The long-term effects of China’s using its money to increase its people’s standard of living, and the United States’ becoming less dependent on one lender, could even be positive. But that rebalancing must happen gradually to not hurt the value of American bonds or of China’s huge holdings.
Yves here. I hate to say this, but if China were to be rational about their Treasuries, they are a sunk cost. Will China realistically ever see 100 cents per dollar invested? The answer is certain to be no. The US is out to create inflation (as a matter of policy, to avoid deflation taking hold). In addition, the massive federal deficits in the pipeline, plus the high odds of a somehow cosmeticized bailout of the Fed down the road (it has been hoovering up crappy assets certain to be worth less than their reported value) will necessitate a default via inflation. And since China has run double digits inflation, they really can’t complain if we go that course. And that’s before we consider that the powers that be, like just about every economy in the world, presumably want their currency to be weaker (a weaker dollar would also erode the value of US government paper). How that race tot the bottom plays out is anyone’s guess.
Very few seem to be looking at the gives and gets in a hard-nosed fashion. China has to know the Treasuries it holds will, under NO plausible scenario, be in economic terms worth face value. In fact, were there any realistic way for them to dump them now, that would probably be the value-maximizing course of action. Pull out a calculator and start playing with, say, 12% inflation over 6 years. It is remarkably destructive.
Now the powers that be would no doubt deem 12% inflation to be barmy, but given the level of deficits in the pipeline, one could argue that we need inflation of that order to avoid explicit default.
That does not mean China will dump Treasuries, but merely that any cold-blooded analysis needs to start from how bad likely scenarios would be for the Chinese, what actions are open to them, and how they affect risks and outcomes. I don’t see much evidence that anyone has put together a decision tree from the Chinese perspective.
Back to the story:
Another danger is that investors will demand higher returns for holding Treasury securities, which will put pressure on the United States government to increase the interest rates those securities pay. As those interest rates increase, they will put pressure on the interest rates that other borrowers pay….
Yves here. Why did the Times not mention that prices (and hence yields) are set via auction? It makes it sound as if the Treasury has more control than it does (it could shorten average maturities and/or try new structures, but the yield the market wants at a given maturity is the yield it wants for a given volume on offer). Back to the story:
The strength of the dollar against the euro in the fourth quarter of last year contributed to slower growth in China’s foreign reserves, said Fan Gang, an academic adviser to China’s central bank, at a conference in Beijing on Tuesday…
Yves here. No mention, zero, zip, nada, that the reason that China had to sop up so many Treasuries was to keep the RMB from appreciating too much versus the dollar, and that the strength of the dollar relieved China of the need to intervene. Back again to the piece:
China manages its reserves with considerable secrecy. But economists believe about 70 percent is denominated in dollars and most of the rest in euros.
China has bankrolled its huge reserves by effectively requiring the country’s entire banking sector, which is state-controlled, to take nearly one-fifth of its deposits and hand them to the central bank. The central bank, in turn, has used the money to buy foreign bonds.
Now the central bank is rapidly reducing this requirement and pushing banks to lend more money in China instead.
At the same time, three new trends mean that fewer dollars are pouring into China — so the government has fewer dollars to buy American bonds.
The first, little-noticed trend is that the monthly pace of foreign direct investment in China has fallen by more than a third since the summer. Multinationals are hoarding their cash and cutting back on construction of new factories.
Yves here. This is sufficiently incomplete as to be misleading. Michael Pettis has indicated that a lot of the hot money flows into China were disguised as FDI. Back to the story:
The second trend is that the combination of a housing bust and a two-thirds fall in the Chinese stock market over the last year has led many overseas investors — and even some Chinese — to begin quietly to move money out of the country, despite stringent currency controls.
So much Chinese money has poured into Hong Kong, which has its own internationally convertible currency, that the territory announced Wednesday that it had issued a record $16.6 billion worth of extra currency last month to meet demand.
A third trend that may further slow the flow of dollars into China is the reduction of its huge trade surpluses…
Two officials of the People’s Bank of China, the nation’s central bank, said in separate interviews that the government still had enough money available to buy dollars to prevent China’s currency, the yuan, from rising. A stronger yuan would make Chinese exports less competitive…
Treasury data from Washington also suggests the Chinese government might be allocating a higher proportion of its foreign currency reserves to the dollar in recent weeks and less to the euro. The Treasury data suggests China is buying more Treasuries and fewer bonds from Fannie Mae or Freddie Mac, with a sharp increase in Treasuries in October.
But specialists in international money flows caution against relying too heavily on these statistics. The statistics mostly count bonds that the Chinese government has bought directly, and exclude purchases made through banks in London and Hong Kong; with the financial crisis weakening many banks, the Chinese government has a strong incentive to buy more of its bonds directly than in the past.
The overall pace of foreign reserve accumulation in China seems to have slowed so much that even if all the remaining purchases were Treasuries, the Chinese government’s overall purchases of dollar-denominated assets will have fallen, economists said.
Update 3:40 AM: Brad Setser begs to differ: “China hasn’t (yet) lost its appetite for US Treasuries …“
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Yves, this is great analysis. There ought to be a term for a blogger critiquing a MSM article and pointing out its half-truths, evasions, outright prevarications, and lack of knowledge in a cool, dispassionate, and objective manner. I’m sure someone will come up with something soon–and then they could refer to this post as a good example of it.
I guess that if the Chinese central bank stops buying our bonds then our own central bank will be the last one left to do it–and they’ll justify it by pointing out that they need more Treasuries to use in their repo agreements. . .
In addition, the massive federal deficits in the pipeline, plus the high odds of a somehow cosmeticized bailout of the Fed down the road (it has been hoovering up crappy assets certain to be worth less than their reported value) will necessitate a default via inflation.
I feel compelled to repeat myself: I don’t think defaulting via inflation is a straightforward, clean process, and given the political landscape, the state of the Fed’s balance sheet, and the state of private sector banks’ balance sheets, I have strong lingering doubts about whether it’s possible without ensuing hyperinflation.
And since China has run double digits inflation, they really can’t complain if we go that course.
I don’t think that’s fair, Yves. As I’ve mentioned, China was really unable to let their currency appreciate too hard because it would have instantly broken the PBoC.
Running higher inflation in China than in the U.S., as it had been for awhile, was the only other way to have the yuan’s real exchange rate appreciate. If the peg were axiomatic, and it sure looked that way, I would have loved to see sustained moderate inflation in China alongside sustained low inflation in the U.S.
It didn’t work out, and now we’re both falling into deflation. Now consider if the U.S. wants to and is somehow able to create high inflation domestically, but China remains unwilling to break the peg because it still doesn’t want the PBoC to blow up even worse. What must happen to domestic Chinese inflation if we don’t want the RMB to effectively devalue further?
Together, we’ve put together a pretty ghastly dilemma, and I hope we work together to dismantle it. Though I’ve got not the faintest idea how to do that…
I wonder how all this will impact the peg.
If 12% inflation is in the USA pipeline, the dollar will crash.
That would create a dilemma for China. If they don’t follow the dollar down (keep the peg), they take a huge hit to their export market to America.
I think getting off of their addiction to reserve accumulation in dollar assets may be easier to wish for than to accomplish.
ndk,
The China analyses I have read linked the peg directly to China’s high inflation. They were buying foreign assets at such a rate that it had become impossible to sterilize them fully. So they were creating money supply expansion on top of stoking robust exports.
More rapid currency appreciation would have lowered inflation. The high inflation was the result of domestic choices, Thus I stand by my comment that the Chinese cannot complain if we create high inflation in the name of growth. It is a page straight from their playbook.
I am also concerned at how the term “hyperinfaltion” gets bandied about. I have seen some analysts contend that hyperinfation exists at a level as “low” as 20% per annum. I don’t think most commentators have a level of that sort in mind, but that is more than high enough to wreck savings and investment.
More rapid currency appreciation would have lowered inflation. The high inflation was the result of domestic choices, Thus I stand by my comment that the Chinese cannot complain if we create high inflation in the name of growth. It is a page straight from their playbook.
It was their choice, yes. I don’t agree with their choice, but it’s pretty solidly made at this point, unfortunately, particularly after this hot money scare. I don’t think their conclusion will be to float.
What I’m complaining about is that higher inflation in China is constructive. It reduced imbalances by making Chinese wages higher, Chinese goods more expensive, and so forth. It wasn’t great domestically, but it helped the system.
Higher American inflation is probably not constructive for the system. It would make Chinese wages lower, Chinese goods more cheap, and so forth.
Because of that, I see a reasonable chance that it doesn’t even U.S. growth. It could just make all our imbalances worse.
Let me put that into a hypothetical sequence of events:
1) The U.S. increases domestic inflation to 12%, somehow.
2) China refuses to change their currency peg because they can’t suffer the collapse of the PBoC.
3) The Treasury bonds China’s holding lose the majority of their value, but are held to maturity, and China is buying a phenomenal amount of dollars again anyway.
4) China’s inflation rate is slower to adjust given their huge structural overhang of both labor and capital and less developed(or parasitic, your choice) financial sector. Remember that despite the burst of inflation around ’06-’07 due to food and bubbles, China ran very low inflation rates in the early part of the decade. It’s likely even more structural now after the burst.
5) Chinese labor and production appears to become much cheaper.
6) The export machine refires.
And remember that there are many pegs out there besides China’s. Somehow, you’d have to convince all of them not to go through this loop with us.
Unless I’ve made a substantial mistake here, I honestly think the most probable outcome from the U.S. even successfully inflating away its debt is to make the U.S. even less competitive, and to give a substantial boost to peggers’ exports and economies.
And that’s why I object to it, and why I would be thrilled to see the rest of the world inflate. Or, we could just deflate, ourselves… heh.
ndk,
With all due respect, your point on inflation in China is the reverse of how pretty much everyone sees it. China’s currency has been so significantly undervalued that even after letting it appreciate somewhat for the last two years, Nouriel Roubini (who with Brad Setser wrote a book on Bretton Woods 2, so this is a particular area of interest) concluded that even a one-time revaluation of 20% would be inadequate, and the Chinese wouldn’t stomach it anyhow, but that domestic inflation would eventually do what a properly priced currency would do sooner.
@ndk,
I don’t think that’s fair, Yves.
Maybe fairness is difficult to determine. The kind of inflation Yves mentiones is in effect the concession that all the dollars the Chinese got for their exports are not as valuable as previously believed. But isn’t the same true for many of the exported goods themselves? How much worth is all that crap Americans bought all down the years filling their closets?
China’s currency has been so significantly undervalued that even after letting it appreciate somewhat for the last two years, Nouriel Roubini (who with Brad Setser wrote a book on Bretton Woods 2, so this is a particular area of interest) concluded that even a one-time revaluation of 20% would be inadequate, and the Chinese wouldn’t stomach it anyhow, but that domestic inflation would eventually do what a properly priced currency would do sooner.
I don’t see where I disagreed with any of that, and I’d appreciate it if you pointed that out for me. I think a substantial revaluation is quite necessary through either higher Chinese inflation or an upward revaluation of the Yuan. Setser put it very well in ’05:
keeping the peg helps avoid deflation in china but puts downward pressure on wages and manufactured goods prices in the rest of the world; a revaluation increases the risk of deflation in china (that’s why it needs to be accompanied by offsetting policy changes) but helps the world.
With all due respect, your point on inflation in China is the reverse of how pretty much everyone sees it.
Which point? Structural low inflation? The increase in Chinese inflation inj ’07 and ’08 coincided precisely with the commodity bubble and was almost entirely raw materials, energy, and food. This has led to a lot of head scratching. Pettis has a good recent post that chronicles the debate between him and the “pork camp”.
ndk,
The high domestic inflation is considered pretty widely to be the result of the currency peg that has gone on so long and at such a level that the foreign asset purchases could not be sterlized. And other policies also fed inflation, such as super low deposit rates (0.5%). One economist commented, “If I wanted to create hyperinflation, I’d be hard pressed to do a better job.”
So again, I do not see how the Chinese can cavil if we create high inflation to support growth. The global commodities bubble was particularly damaging to low income countries, and demand from an overheated China was a significant culprit ( I read the causality ex food the reverse of the way you do, save that energy prices also feed into ag production costs). I don’t see their policy as benign, particularly since the trade surplus widened in 2008.. It was not leading to a rebalancing.
pigeon,
Maybe fairness is difficult to determine. The kind of inflation Yves mentiones is in effect the concession that all the dollars the Chinese got for their exports are not as valuable as previously believed. But isn’t the same true for many of the exported goods themselves? How much worth is all that crap Americans bought all down the years filling their closets?
I meant "not fair" from the perspective of the system, not morality, sorry; it hurts the system and makes the future even worse. Thanks for calling that out. High Chinese inflation and low American inflation is good for everyone in the end, but the converse is bad in the end.
To put it succinctly, if the RMB/USD rate is pegged, then American Inflation > Chinese Inflation -> Weaker Real RMB. Chinese Inflation > American Inflation -> Stronger Real RMB.
We all want a stronger real RMB, particularly Setser and Roubini. If American inflation is increased above and beyond Chinese inflation and the peg is maintained, the real RMB weakens and all our imbalances only get worse.
Good analysis Yves. Thank you.
How does the the recent move by China to settle overseas trade in Yuan rather than in USD figure into your analysis? Link below:
http://www.shanghaidaily.com/sp/article/2009/200901/20090107/article_387229.htm
I read the causality ex food the reverse of the way you do, save that energy prices also feed into ag production costs
I’m not really committed either way on the causality, only pointing out that others are debating it.
So again, I do not see how the Chinese can cavil if we create high inflation to support growth.
Because unless they wind up with even higher inflation than we do(which might happen), we’re only supporting their growth, reducing our propensity to invest in tradables, and the imbalances, including the RMB undervaluation, just get worse.
China probably doesn’t want to have to run 16% inflation to accommodate our need for 12% inflation and systemic rebalancing, I suspect, and would fight against that pretty vigorously. Reasonable people can argue about whether it’s possible. I think it is. We’ve seen time and time again that the connection between total money supply and interest rates is tenuous at best.
I don’t see their policy as benign, particularly since the trade surplus widened in 2008.. It was not leading to a rebalancing.
Me neither. But things can be headin’ from bad to worse.
Thanks for obliging me, Yves. I’ll let you get some sleep now.
ndk,
Competitiveness is not simply a function of wages. Indeed, we have made a huge mistake in overplaying this issue. Wages are a pretty small component of a lot of finished goods, and there are other ways to compete besides price (product differentiation, proximity to customer, service quality, warranties, etc). Germany is both high wage and an export powerhouse.
In addition, the US is very likely to wind up with a much weaker currency. People seem to forget that high interest rate currencies were once shunned because they were expected to depreciate. Stocks at various point in time have been seen as an inflation hedge and inflation victim (Jim Grant has written at length about how this and other investment attitudes have changed dramatically over time).
What a bad theater none of the actors are working in unison damm, hate that when it happens, must be the cheap seats.
Skippy
You tempt me so. I agree that there’s a lot more to competitiveness than just wages, but wages are an awfully big expense and play special roles in fueling an economy.
Germany is both high wage and an export powerhouse.
I don’t think the German wage story is so positive now that China’s presence in global markets has grown so large. Real wages haven’t increased since 2004 or 1986 depending on your source(in my defense, that’s the first that came up in a search). The wage gap is widening quickly, and before this wage stagnation we were talking about Eurosclerosis.
Their persistent trade surplus is quite impressive, though December’s not looking so good for Germany either. Oof.
In addition, the US is very likely to wind up with a much weaker currency.
Probably, but IMO only as a result of crisis. Until then, I don’t expect much devaluation. This would, of course, also bankrupt the PBoC, unless they came along for the ride — and they might happily do so, because then they could sell to Europe.
People seem to forget that high interest rate currencies were once shunned because they were expected to depreciate.
Youth and ignorance together afford me an excellent alibi.
How can the US solve its fiscal problems with inflation? The average voter makes their money from wages and has stagnant wages. Inflation would screw them over. Why won’t there be a massive populist backlash if the US government starts running massive inflation?
Can someone give me a quick tutorial in how this works: “China buying USA Treasuries keeps the Yuan from appreciating?”
In a new york times article on the subject it pointed out that Hong Kong has printed an extra 16.6 billion dollars worth of currency as Chinese companies are keeping more of their dollar revenue overseas instead of bringing it home and converting it into yuan. This I think is a recent dynamic which is rapidly changing the situation. The article also quotes one Dariusz Kowalczyk, the chief investment officer at SJS Markets Ltd., a Hong Kong securities firm as saying the pace of foreign currency flows into China has to slow, and therefore the pace of China’s reinvestment of that foreign currency in overseas bonds will also slow. So that is two individuals from the financial community in Hong Kong raising a warning flag.
The article also reports that Cai Qiusheng a senior central bank official reporting the foreign exchange reserves had dropped. Stephen green at standard chartered bank in china says this is due to withdrawals by foreign investors but also interestingly due to devaluation of the Renminbi.
HSBC economist Qu Hongbin meanwhile says that although export growth rate is on the decline, its import growth rate has also declined which fits in quite neatly with want Brad Setser says. He also belives sinceChina holds quite a lot of European assets the drop in reserves may be due to drop in the Euro to U.S. dollar exchange rate changes.
While up to November of last year the Chinese authorities worked to keep their currency from appreciating, are we sure that this is still the case. Pei Changhong, director of the Institute of Finance and Trade Economics under the Chinese Academy of Social Sciences perhaps gave a clue when suggesting the Renminbi ought to devalue against the Euro since the European Union is now China’s largest export destination. Stephen Jen over on the morgan Stanley global economic forum has changed his mind about china in an article entitled Changing My Call on the Chinese RMB where he sees china letting its currency devalue by upto 10 percent. A depreciating Renminbi would cut the prices of imports into the US even further and since imports are more often dollar priced than exports this could have an impact on chinese reserves (perhaps thats why China will settle overseas trade in Yuan rather than in US dollars). Still will the money flows be strong enough to force china to relinquish its steely grip on the dollar Peg.
What tends to be skipped over though is the part inventories play in export and import trade. We suspect that unsold goods inventories are building, leading to a crash in manufacturing. Once those retail inventories are sent out does manufacturing pick up a bit. We also suspect that supply side commodity inventories especially iron ore was being worked through as China renegotiated on prices, so will china’s commodity buying pick up a little during 2009. If this is true we might expect big swings in China’s reserves as these inventories change.
Brad setser in his looking back at 08;thinking at 09 in the comments asks what am I missing and I think the answers may be some sort of shock the harbingers of which may start appearing soon. With germany’s bond failure this week you cannot help thinking the printing presses will start up, todays treasury auctions ought to give some insight I think.
Yves, this time you have the Times nailed. Leaving currency pegs out of this article is an outrage.
I disagreed with your criticism of the Times’ article on economic forecasts, so I have to credit you here.
The federal government and State Legislatures may want to loan money to manufacturing companies that make products in our country. Some of the companies could be foreign companies. Some of the companies could be small companies. Our economic growth may increase and we may be better able to reduce our national debt over time. Companies that make products in our country may cause less air pollution, land pollution, and water pollution on our planet than companies that make products in China.
If the federal government is serious about growing the economy and creating jobs, it should stop taxing interest from savings accounts, dividends, capital gains, and estates. Individuals and businesses will have much more incentive to invest in poor parts of our country. Individuals and businesses would have more money to spend. Middle class people, union members, and government employees who have mutual funds would benefit from capital gains and dividends not being taxed. Businesses would have an easier time obtaining loans and investments for hiring workers, research and development, and plant and equipment. Wealthy people and others might be more likely to donate to homeless shelters, soup kitchens, and food pantries.
I posted comments after Matthew Leiphon’s “STATE BUDGET WOES” located at http://www.newgeography.com/content/00497-state-budget-woes
My website is http://www.myspace.com/kennethstremsky
I graduated from the University of New Hampshire in 1992 with a BA Degree in Political Science and a minor in Economics.
I ran for United States Senate in 2002.
Yves wins the debate with ndk.
Good for China about time they slaughter this fat pig besides that they have their own problems and welfare starts at home right?
If your were Chinese and you realize that money is becoming a scarce resource you keep and spend your money at home.
If you were Chinese and you can decide whether to buy a German Bund or a US Treasuries you are most likely to invest in the German Bund…Yet German Bund auctions are not going very well recently…That means that there will be a lot of treasuries and bonds from various and competing countries. I wonder who is buying something yielding zero or less…
Yves:
four things:
a) Apart from ignoring the peg, the basic problem of the Bradsher article is that it ignores the recent TIC data. the TIC data has its flaws, but it actually shows a huge rise in China’s total monthly purchases and its treasury purchases — basically the last available data points to the opposite conclusion as the article.
past behavior is no guide to the future, but what this story needed to lay out why record chinese purchases of us assets/ us treasuries in oct isn’t a good guide to the future.
b) Reserve growth isn’t quite the same as the evolution of China’s current account. the data for q4 strongly suggests an ongoing increase in china’s current account surplus, as imports have been falling faster than exports. a fall in trade need not imply a fall in china’s trade surplus — think of the impact of falling commodity prices. The balance between falling imports and falling exports may change over time, but right now it still suggests a bigger not smaller trade/ current account surplus amid a fall in global trade. the big adjustment to the world’s balance comes from the oil exporters.
c) the chatter from china about falling reserves isn’t yet conclusive, as the Oct/ Nov data was shaped by the euro’s big fall (probably a $60-70b hit to china’s reserves). the fall in the AUD and GBP also didn’t help. end December will be more telling — as the euro’s rebound reduces the impact of valuation. let’s see what that number shows. My guess would be a small increase in q4, one less than the trade and current account surplus — i.e. there were large hot money outflows. the PBoC generated some of these outflows itself when it knocked the rmb down a notch in early december …
d) hot money outflows financed by a current account surplus that go into offshore dollar accounts (or into HKD and drive up hong kong’s reserves) still finance the US … hot money outflows only reduce the financing for the us if private chinese savers are less inclined than SAFE to hold $.
all in all, some fall off in reserve growth and treasury purchases is likely — and in my view more likely than a large fall in the trade surplus (barring a recovery in commodity prices). but the available data as of now suggests:
a)a rise in the trade surplus
b)some fall in the pace of reserve growth (but we need the actual data not leaks … esp. the end dec data)
c)a shift in china’s reserves toward treasuries (from agencies) and perhaps toward the dollar — as $70b in oct purchases is kind of high, but this strikes me as suspicious.
the strong pace of oct cannot be sustained, but i still think the main problem with the bradsher piece is that china’s recorded treasuries actually set a record in oct — and that sort of was ignored.
bsetser
China’s appetite for treasuries has already fallen off but they don’t have a system that responds as quickly as the U.S. Their strategy is a slow evolution.
It has been amazing to see the rapid response in 2008 of the Treasury and Fed. The TARP was thought to be absolutely necessary to prevent systemic meltdown and yet almost half of it is still unspent. Perhaps we would be better off with a bit more reflection prior to major decisions.
The problem with the official data is that it doesn’t capture the real phenomena of private transactions with regard to people in China who need to have assets outside of China (and not in RMB) as a hedge against the government going “south” on them.
What has happened is that these “private” investors have largely shifted their investments away from USD denominated investments, to Euros, to Singapore, HKD, anything else but RMB and USD.
That explains some of the conflict between the official and unofficial numbers at this time.
D
China is the biggest bubble of all. I live in an area where many Yankee traders made their fortune (and many lost that fortune) in the China trade of the last century. The rich ones tell stories of how their ancestors got out when the going was good. The poor ones mourn how their ancestors thought that the China bubble would last forever because it was a large country, with cheap labor, etc.
China will burst.
You heard here furst.
So don’t you curse
When your wealth ends up in a hearse.
Competitiveness is not simply a function of wages. Indeed, we have made a huge mistake in overplaying this issue. Wages are a pretty small component of a lot of finished goods, and there are other ways to compete besides price (product differentiation, proximity to customer, service quality, warranties, etc).
Most of the things you site here are a reflection of wages, or labor. Proximity (i.e. shipping), or lack thereof, is a labor cost. Service is a labor cost. Product differentiation , either through marketing or engineering, is a labor cost. There is more to wages then what happens on the manufacturing floor. The cost of something is largely , but not wholly, determined by the labor that went into it.
NDK said:
Higher American inflation is probably not constructive for the system. It would make Chinese wages lower, Chinese goods more cheap, and so forth.
In my mind, this is a powerful point. Yves argues that we would be taking a page from the China playbook by inflating away debt and they could not blame us too much. But, high inflation/growth in a developing country with low wages and significant development yet to occur is completely different than inflation in an overconsuming, overly indebted society like our own in the US. Development in China is very patchy and immature in many ways. China I believe is more justified in an inflationary approach, and they would certainly tend to view it that way themselves. I think it is fiendishly difficult to judge their government’s motives.
Note that my view is colored by my experiences in China
With all due respect to Brad Setzer, I believe his argument relies on a flawed assumption.
China’s trade surplus will increase, he says, because their terms of trade — a function of oil prices — are improving. Therefore more money to finance the U.S. deficit, therefore less need for the Fed to finance it, therefore little risk of monetization/inflation.
Let’s look at it another way: the U.S. has trouble financing its deficit; it monetizes; real asset and commodity prices rise in dollar terms; given the China’s peg, its terms of trade deteriorate; less money is available to finance the U.S. deficit, more chance of further monetization/inflation.
The point is, if you start with the premise that U.S. dollar inflation is unlikely, then things look okay (sort of). If you relax that assumption, the whole scenario changes. I believe too many analysts — even the best ones like Brad — make the implicit assumption that U.S. inflation cannot occur in the presence of an output gap. That assumption is like saying “house prices never fall” — it drives everything else.
Can someone give me a quick tutorial in how this works: “China buying USA Treasuries keeps the Yuan from appreciating?”
Wikipedia has a very good explanation for you, Joseph. The statement you cite includes the two end effects, but this will show you what the process is.
After a night’s sleep and some reflection, I feel more confident about my earlier conclusions. If America successfully introduces domestic inflation, it will reduce our competitiveness with pegged countries and stimulate their export sectors.
By the same coin, these pegged currencies make it much harder for us to create domestic inflation, because we’d have to generate more inflation in their countries than ours to prevent downward pressure on domestic labor and capital pricing. This is just another reason why I still don’t think we can create lasting inflation in the wage/price sense, so I don’t expect to have my first hypothesis tested.
These are testable, so we’ll see how they fare in the future. Hold me accountable, folks. :D
By the same coin, these pegged currencies make it much harder for us to create domestic inflation, because we’d have to generate more inflation in their countries than ours to prevent downward pressure on domestic labor and capital pricing.
One last thing: these conclusions are all barring a trade war. I have no clue what a trade war would do to relative pricing. If you’re betting on significant inflation in the U.S., I’m almost certain you’re by proxy betting on this trade war.
I was about to agree with both Brad Setser as well the ‘anonymous’ poster above who articulated points a/b/c/d… before realizing they are one and the same.
Yves, there’s nothing necessarily contradictory in seeing an increase in current account surplus co-exist with a decrease in national reserve. It seems likely at this point (at least as of 4Q08) that was exactly the situation China found itself in.
I also agree with ndk’s point. I don’t believe he was disagreeing with you that the United States can morally make the argument that stoking domestic inflation would help address American debt and trade issues… I think he was making the point that trying to do so would ultimately have the opposite effect, at least from the trade perspective vis-a-vis China.
Yves,
Here is a great article from Spiegel about what is going on in China with the labor force.
http://www.spiegel.de/international/world/0,1518,600188,00.html
I have for a while believed that China would get tired of buying US debt and want to to actually do something significant with the money rather than let its hard won reserves burn in the fires of dollar inflation.
Consider how it works. China mass produces products and US consumers consume them. China gets paid in dollars for its blood, sweat and tears. But a dollar is a zero-coupon bond – an IOU. So China wants to buy something with those IOUs. It buys Treasuries – which pay a coupon but are still more IOUs!
Tired of this China actually tries to buy real assets. But what a fuss results! Consider the rebuff when CNOOC tried to buy UNOCAL. This isn’t fair – China finds that dollars can be used to buy debt but not equity! (Compare that to the UK which happily lets China build stakes in BP, Shell, BG..)
So China gets to buy less attractive US equity (Blackstone, JC Flowers). This isn’t working. And the yields on Treasuries have collapsed. Treasuries look like yet another bubble.
So what do they do now? I think Setser is to sanguine about China’s view on this. China tiring of owning debt is a tipping point.
You pro-inflation types need to explain why there won’t be a massive populist backlash that prevents inflation. The reason for one is simple: most voters make almost all their money from wages that have been stagnant, and so inflation will drastically reduce their standard of living.
Once voters lifestyles start being crushed by inflation, they will vote out any and all politicians that support it.
I don’t believe he was disagreeing with you that the United States can morally make the argument that stoking domestic inflation would help address American debt and trade issues… I think he was making the point that trying to do so would ultimately have the opposite effect, at least from the trade perspective vis-a-vis China.
In apparently a pretty clumsy way, but yes, that’s exactly the right interpretation. Chinese inflation is beneficial to the debt and trade issues. Thanks for persisting, 1:38.
The reason for one is simple: most voters make almost all their money from wages that have been stagnant, and so inflation will drastically reduce their standard of living.
If the inflation that we can generate doesn’t boost wages, then you’re right, 1:59. But I’d argue that’s not inflation, at least not in a lasting sense. It’s more asset bubbles. Our entire problem is that current production and wages can’t even support current asset prices. Driving up asset prices is not sustainable, much less a solution.
if the inflation that we can generate doesn’t boost wages, then you’re right,
And how could it? Simple supply and demand of employment will keep wages down for a long time, in my view. How could it not? Just look at the unemployment spike happening, which is certain to get much worse. So the Fed is not trying to engineer inflation, they are trying to engineer another bubble. It is the most short-term fix imaginable, and it probably won’t work anyway.
“So what do they do now? I think Setser is to sanguine about China’s view on this. China tiring of owning debt is a tipping point.”
I think hindering China from equity purchases is sound. This is because I see pegging the RMB as a mechanism to get their “venture” off the ground as sound but with a price. The price being the acquisition of equities with this start-up capital (pegged RMB).
Also once the Chinese economy achieves somekind of maturity (perhaps within a decade or so) they should allow the RMB to float (grow-up).
Also another factor the Chinese leadership should understand is the real need of democracy to go hand in hand with capitalism. Communism is a good start-up mechanism (like pegging the Dollar) to maintain a consistent “rudder” during the ramp-up to full capitalistic machination but will create huge problems with this aggegrated power. The power once at a strong level should be dissipated back to the people to stabilize future growth and stability.
The biggest factor affecting China’s current leadership is the desire to leave a legacy of their efforts (real harbinger of democrcy). This desire will allow the transition to occur. And if they achieve their legacy, monuments should be erected in their honor. Those future monuments would mean allot to me (American cowboy). Respectfully.
ndk said…
if commodities remain priced in dollars it is well within the power of the Fed to inflate. The problem with inflation is that it helps only the US since they are printing the money and handing it out. Everyone else is scrambling to buy the hard goods (or will eventually) as their business(or employer) margins compress. The idea that the fed can create inflation is without question (they could devalue the dollar tomorrow and do it) but the idea that they can create “good” inflation [by this I mean wage and or embedded returns] is the greatest myth going. The Fed is acting to inflate while at the same time working to surprises the yield curve and mitigating the only path possible for many people to capture returns that outpace their cost of living escalation. The Fed is systematically working to disenfranchise the majority of America as most will soon learn when the commodity complex blows apart.
If you were sitting at a Bilderberg meeting and thinking about survival strategies (i.e incumbency protection) it seems the lone strategy is to reassert “confidence” some how. FDR said it was just confidence that mattered to currency. The US only hope is to have the rest of the world go into absolute chaos while we suffer depression so that we can continue to capture rents. It is simply a mesmerizing that there remains a segment in Government/Fed that believes redemption is in the cards and the world will once again re-embrace the dollar, debt and ethos of the US. This as the US conducts arch unilateral economic policy in the name of saving the rest.
On the topic of trade war, consider the announcement by Japan about the tax regime they are considering attracting foreign capital: no capital gains. German is contemplating $10B loans to small and medium companies. South Korea thinking about $38b in loans to similar sized companies. France today injected another $10B into the banks and calling it “quasi” equity a la Sweden.
Exactly when and where does the excess capacity get destroyed (from the fantasy land bubbles era)? We are already engaged in a trade war of sorts, it is just war by other means – Pegs, tax incentives, Guarantees, Loans, Devaluation/inflation.
Seems to me the debate about relative inflation rates is more an academic one, albeit on point. The Chinese are using tax rebates and capital infusions to stimulate and or sustain whole industries….to get them through until “normal” returns.
I noted yesterday the FT had the Chinese shopping for jr. miners and mining properties. And fully agree that those reserves become more of an albatross the longer they are left in dollars. The US may have created the smartest of smart bombs – only this one when deployed will leave attacker dead too.
Can Chinese gov afford to generate higher inflation without job and wage increase ? do not forget, majority of chinese people are still very poor, food inflation will be unbearable and cause civil unrest (social stability is top 1 priority for government), it is going to be a tough choice.
a lot of these discussions forget the likely third part of the obama administration’s gameplan, namely:
1) borrow a lot of money for fiscal stimulus / bailouts
2) generate a lot of inflation / devalue the dollar
3) impose restrictions on competing (i.e. chinese and other manufacturing) imports
the third part is crucial. basically the us govt needs to borrow as cheaply and quickly as possibly to finance its fiscal stimulus while the chinese and others are still in currency peg mode. then it needs to do everything possible to destroy the chinese and other currency pegs to the dollar (or their effectiveness in promoting exports to the usa).
i would also add that ndk’s analysis overlooks the important point that a real exchange rate adjustment via deflation is much much more painful than one achieved via devaluation (with positive inflation). to list the usual rollcall of reasons:
– positive real interest rates as nominal rates are floored at zero, leading to excessive savings / deferred consumption
– rising real value of debt in a heavily indebted economy
– nominal wages are much more sticky downward leading to high real wages and excessive unemployment
i would also add that ndk’s analysis overlooks the important point that a real exchange rate adjustment via deflation is much much more painful than one achieved via devaluation (with positive inflation). to list the usual rollcall of reasons:
I don’t think I’m overlooking that at all, though I didn’t call it out as loudly as I should’ve, bena. If deflation were okay, problem solved: we don’t have to ask the peggers to do anything. Nature takes its course as the U.S. deflates faster than they do.
Deflation is indeed precisely why we really need China and other peggers to inflate more than us do, but we might not be able to force them to do it.
Let me put it bluntly: the U.S. would be asking China to run 16% inflation so it can gradually default on its debt.
If we can’t convince them to do that, then any higher inflation we generate will only make the predicament worse.
ndk
you overlook my main point, which is that an undervalued rmb is of little help against explicit import restrictions / taxes
you overlook my main point, which is that an undervalued rmb is of little help against explicit import restrictions / taxes
Naw, bena, I mentioned earlier:
“One last thing: these conclusions are all barring a trade war. I have no clue what a trade war would do to relative pricing. If you’re betting on significant inflation in the U.S., I’m almost certain you’re by proxy betting on this trade war.”
I don’t think a trade war is a good outcome in the long run for anyone, but I’m actually open to the question. If our problem really is overcapacity, low wages, deflation, and excessive competition from superior overseas competitors, what better solution than tariffs? In the short run, at least, it’s pretty obvious. And short run solutions have looked pretty good to us so far.
Although things can change, at this point I still firmly believe that labor trends in China will not translate into significant social unrest. The migrant worker Chinese losing their jobs at the moment have, typically, only worked for a few years (vast majority less than 5). They are also likely the only ones in the history of their family to hold this particular type of job.
The idea that migrant workers will be unable to adjust to unemployment (more accurately: re-adjust to rural labor) is, in my opinion, simply not accurate. They’ll just go back to the lives they lived 5 years ago (and which their ancestors lived for thousands of years)… except significantly wealthier than they were 5 years ago.
I would be more concerned about collective anger amongst blue-collar workers in the United States, who have few alternatives, and who have collectively worked well-paying factory jobs for at least three generations.
I just came back from Shenzhen, in Guangdong. Although it’s a small sample size.. I can tell you that it was very difficult finding temporary labor to help out around the house, and their pay was still substantially higher than 12 months ago.
I’m also not sure that commodity inflation will be especially painful for the poor in China. The only cost input that really affects the poor in China are food prices, which is less correlated to global commodity prices. That’s not say it’s not correlated… energy/fertilizer costs would definitely affect food costs… but I just don’t see it as a very significant affect in the short-term.
@Anonymous 3:47
I think the time period where factory migration has been increasing in China is a little longer than 5 years – maybe more like 15 to 20.
But your point about unrest is well taken. China is in many ways closer to how the US was in the 1930’s – not too many years out from an agrarian society and potentially able to have a larger share of its population go back to that way of life if needed, as many did here in the GD. If you look at the newly unemployed numbers in the context of China’s overall population size, they are not so large. So I am in agreement that the near term threat of social unrest is not significant. It may change with a worse downturn, however.
What bothered me when I was in China was that I heard plans for the government to extend their capitalist experiment into the rural food chain, by trying to organize returning workers into businesses that could take more control over more of the food supply chain. This did not strike me as a particularly good idea.
Commodity inflation will hurt in the cities, however.
Yahoo…
French President Nicolas Sarkozy, leading a two-day conference with former British Prime Minister Tony Blair on the future of capitalism, said the crisis has shown that no country can go it alone on economic policy.
“In the 21st century, there it is no longer a single nation who can say what we should do or what we should think,” he said.
German Chancellor Angela Merkel said the system “cannot continue as it is” and called for better-regulated financial markets.
Good bye boarders or here comes real internationalism.
The tribes of Easter Island, competing for the annual prize. Where all the others must provide them with the best of their efforts.
Many today see Easter Island as a metaphor of the modern world. With haunting and obvious parallels, our earth is a tiny island floating in the vastness of space. Globalization, trade and communication have united various “tribes” on our “island.” With “tribes” of nations bound together in a global network, humanity is responsible for planning, controlling and using its valuable—and limited—resources.
The shortsighted decisions made on Easter Island caused the complete destruction of its environment and inhabitants. All tribes were guilty of the sentence they brought on themselves.
Most today believe this scenario could never happen again. Yet Easter Island stands as a stark reminder for those who believe in endlessly exploiting earth’s valuable resources—a testament to mankind’s inability to solve its problems.
Best way to study a society’s curve, is in their garbage dump.
Skippy
The Princeton Sims article on monetary/fiscal policy cited by ndk is crap.
The paper is totally ignorant on the true relationship between the size of excess and required reserves. It also makes a huge deal about Treasury deposits at the Fed, which are in the process of being unwound as comments are being made here. And the analysis of cental bank solvency is all wrong.
wintermute said…
“I have for a while believed that China would get tired of buying US debt and want to to actually do something significant with the money rather than let its hard won reserves burn in the fires of dollar inflation.”
Like the Medici’s of Florence, Italy, when they lent to sovereign nations, they weren’t always repaid in “coin of the realm” – nor did they exect to be. Rather, side deals and other forms of concessions were made. The Chinese government will exact value from their Treasury holdings. You can be sure the U.S. government will offer, and has probably already offered up enticing non-monetary “policy” concessions more valuable than paper money.
I love dissent with the experts as much as the next guy, 8:50, but only when cogently argued. You suggest he has several things wrong. Can you explain how and why he’s wrong, and offer a better explanation?
ndk:
Page 6:
“More than 25% of its liabilities are in the form of a special deposit from the Treasury. This has in itself major implications for Fed independence.”
This is absurd. Treasury funding was required only as a temporary sterilization measure while the Fed was in the process of implementing its currency swap program and at the same time moving to an interest earning reserve regime. Treasury has announced it is unwinding its deposits and you can see clear evidence of this on the weekly Fed balance sheet statements.
Page 8:
“The monetary base has expanded dramatically — over 20% in the last month, 15% in the last week, but excess reserves—reserves in excess of reserve requirements — which used to be a tiny fraction of the total, are now the same order of magnitude as required reserves.”
This is also absurd. Excess reserves at the Fed are now about 90 times required reserves, and this is a recent enough paper – hardly the same order of magnitude.
I won’t go into why he doesn’t understand central bank solvency – I don’t have time – but the evidence clearly suggests the author is technically and practically unqualified to be presenting a paper on this subject. It is non-credible on that basis.
Yves:
I want to put a different spin on the Chinese reserves:
“The government may raise the poverty line to enable more people to get State benefits to meet their needs, officials and experts said yesterday.
The State Council, or the country’s cabinet, will discuss such a proposal by the end of the year, Renmin University of China professor Wang Sangui said.
Lu Yan, spokeswoman for the council’s Leading Group Office of Poverty Alleviation and Development, confirmed that the authorities were considering the proposal but declined to give details.
The cost of living in China is lower that in many other countries, hence the existing poverty threshold is an income of 1,067 yuan ($152) a year.
So if the proposed 1,300-yuan-a-year ($186) income (equivalent to $1 a day in other countries) becomes the new threshold, the number of Chinese living in poverty would almost double to 80 million.
About 43 million people were living below the poverty line in the country’s rural areas in 2007. Their number in urban areas was more than 22 million.
Such people get a set of allowances from the government, depending on the cost of living in the area of their residence. For instance, an urban poor gets a higher allowance than his rural counterpart.
They get other benefits, too, such as preferential treatment in healthcare and jobs, and their children get free education.
The proposal to raise China’s poverty line was put forward much before last month, when the global yardstick was changed after the World Bank (WB) raised its poverty threshold from $1 to $1.25 a day.
According to the new WB criterion, about 207 million Chinese people were living in poverty in 2005.
That was 77 million more than the estimate in 2004, when the global poverty benchmark for the world was an income of less than $1 a day.
But the World Bank’s new threshold does not change one fact: China has seen the fastest and largest shift from poverty, the experts said.
According to the WB, the number of people living below the poverty line in China fell from 835 million in 1981 to 207 million in 2005. During the same period, their number in the rest of the world fell by 500 million.
The proposed change can serve as a call for China, whose treasury has been increasing constantly, to take greater steps to lift more people out of poverty, said Wang Xiaolu, deputy director of the China Reform Foundation’s National Economic Research Institute.
That is why he has suggested the poverty threshold be lifted from an income of 1,067 yuan to 1,300 yuan a year.
As China moves toward becoming a country with mid-level per capita income, it has become necessary to redefine poverty, Wang said. The basic expenses on education and medical treatment have to be considered to ensure that those in need can create their own opportunities, Wang said.
The country’s economy, growing in double digits for the past few years, should help the government introduce more effective policies to help the poor, he said.
(China Daily September 3, 2008)”
Whether from fear of unrest or rachmunis or a combination of the two, this is what the Chinese leaders achieved out of the Great Bubble.
As a Shanghai businessman told me recently, the multi-trillion dollar surplus was great to amass.But it was secondary to poverty reduction. And so if they lose 1/3 of the value (his number)the real value is the marked improvement in rural areas. Which after all is what Communism is all about
From the NYT: “The long-term effects of China’s using its money to increase its people’s standard of living, and the United States’ becoming less dependent on one lender, could even be positive.”
Nowhere in this excerpt is it stated that China has a plan to increase its peopled standard of living. Was there a mention of a minimum wage increase that I missed?
Does the NYT author presume mistakenly along with most everyone else that if a govt throws money at a problem that it will go away?
The NYT also operates on another mistaken assumption – nakmely that investors can demand higher returns for their holdings. Did they miss the repeated statements from the Fed and Treasury in December that the Fed is going to target long term yields and drive them lower by being the “investor of last resort?” has the author of this NYT excerpt not heard of the infamous “Bernanke Put” under the market yet or his famous May 2003 speech to drive yields down further out on the yield curve than the fed fund rate?
11:31:
“More than 25% of its liabilities are in the form of a special deposit from the Treasury. This has in itself major implications for Fed independence.”
This is absurd. Treasury funding was required only as a temporary sterilization measure while the Fed was in the process of implementing its currency swap program and at the same time moving to an interest earning reserve regime. Treasury has announced it is unwinding its deposits and you can see clear evidence of this on the weekly Fed balance sheet statements.
I agree with you here, but that may not have been obvious when the paper was written. We’ve had a host of other “temporary” measures, particularly those enacted by the Fed, that have lingered. Also, while I think the Treasury and Fed should be merged into some Department of the Reserve Currency, many do still like to think of them as independent entities, and would be worried by any such dependence.
“The monetary base has expanded dramatically — over 20% in the last month, 15% in the last week, but excess reserves—reserves in excess of reserve requirements — which used to be a tiny fraction of the total, are now the same order of magnitude as required reserves.”
This is also absurd. Excess reserves at the Fed are now about 90 times required reserves, and this is a recent enough paper – hardly the same order of magnitude.
It’s actually probably not recent enough. Those numbers were roughly accurate in the beginning of November. Events have just moved extremely quickly.
At some point I would like to hear your thoughts on central bank solvency. I believe whether and how central bank solvency matters will be revealed as the most important issue on the table at some point later in this crisis.
Thanks for taking some time to respond.
ndk,
fyi, this shows reserves balances weekly for the past 6 years or so.
http://www.federalreserve.gov/releases/h41/hist/h41hist8.txt
Required levels were less than $ 20 billion for years.
Actual levels started their expansion to significant multiples of this around mid-September.
11:31
@ NDK
“What I’m complaining about is that higher inflation in China is constructive. It reduced imbalances by making Chinese wages higher, Chinese goods more expensive, and so forth. It wasn’t great domestically, but it helped the system.”
What better way to stoke inflation in China to reduce global imbalances, current account surpluses, stimulate domestic demand, etc than to legislate minimum wage increases in China by 12% ( I chose this to match Yves 12% hypothetical) a year for the next 10 years.
Wouldn’t this be a big problem-solver?
“If our problem really is overcapacity, low wages, deflation, and excessive competition from superior overseas competitors, what better solution than tariffs? In the short run, at least, it’s pretty obvious. And short run solutions have looked pretty good to us so far.”
With the widening of the wage gap resulting from the pursuit of status quo policies, what other end result is possible?
fyi, this shows reserves balances weekly for the past 6 years or so.
http://www.federalreserve.gov/releases/h41/hist/h41hist8.txt
Required levels were less than $ 20 billion for years.
He says same order of magnitude, 11:31. I see 47618 required vs. 267905 excess for October (the H.3 is the easiest data series). The second derivative of excess reserves was fluctuating wildly at that time, not that it’s slowed down much. I think his statement is appropriate, and better than trying to excessively precise when “really titanic compared to anything in the past” suffices.
What better way to stoke inflation in China to reduce global imbalances, current account surpluses, stimulate domestic demand, etc than to legislate minimum wage increases in China by 12% ( I chose this to match Yves 12% hypothetical) a year for the next 10 years.
Wouldn’t this be a big problem-solver?
It could have, if the marginal productivity of labor in China is that high and labor is that short. Neither is likely the case, so I think it would probably just lead to serious unemployment problems.
With the widening of the wage gap resulting from the pursuit of status quo policies, what other end result is possible?
Well, I don’t see any good options, but a trade war is really bad for everyone, and probably worse for the U.S. Resorting to protectionism in order to avoid paying off debt is a notch up, even for us.
China’s already trying to get a WTO panel formed to address grievances over the existing U.S. anti-dumping regulations, and they have a decent case. I’d love to see currency rules imposed by the BIS, but I don’t see that happening any time soon.
Ndk,
Before I retire for the evening, my brief comment about the solvency issue is that it is as moot as the government deposit issue.
The fact is that the Fed has been granted the power to pay interest on reserves by the government. It would not have started quantitative easing without it. And it’s all the power it requires to stay independent insofar as these types of technical issues are concerned.
With payment of interest on reserves, the Fed only needs to move the funds rate higher (along with reserve interest) in order to respond to inflation risks. Reserve interest will put a floor on interest rates (there is one other small technical glitch that needs to be ironed out regarding certain exception deposits that don’t earn interest, but that will be dealt with by the time the next tightening cycle starts). So the Fed doesn’t need to drain reserves because there’s no longer any extra interest rate leverage from doing that. So it doesn’t need to sell assets to force rates higher. So it doesn’t technically need performing assets. So it doesn’t technically need to be balance sheet solvent. So it doesn’t require technical government backing to recapitalize it. So the government doesn’t have monetary policy leverage just because of the bad asset and solvency issue. And if the government is stupid enough to reject a technical recapitalization if required and requested, the Fed nevertheless won’t feel the effect in terms of its interest rate decisions and their effectiveness.
And if the government is that stupid, and that determined to hyper-inflate, it will simply change laws for the Fed’s operations anyway, without having to use these types of technical solvency issues as political leverage over the Fed. So the entire discussion about Fed technical solvency is a bit silly.
Anon of 1:36 AM,
I am not confident that interest rate increases are an effective mechanism for combatting excessive liquidity. The Fed put through, what, 16 rate increases and it did nada to stanch the housing/credit bubble. It started to implode not due to higher rates (credit spreads were still astonishingly tight even at the time of the Bear hedge fund collapse) but because evidence of borrower insolvency was growing. It was the recognition that the lending had been reckless, and the growing recognition that a lot of securitized paper was a heck of a lot less safe than buyers thought it was, not the Fed’s rate increases, that started the credit contraction.
Yves,
I don’t disagree with your broader point.
My point related only to the Fed’s interest rate policy effectiveness and independence, given the government’s potential to refuse to recapitalize it in the event of asset losses.
Now I’m done for this evening.
And when a security such as mbs’ become recognized as being shaky collateral at best, the slightest rumor can create a run on the entire asset class.
Just prior to the onset of the credit crunch in August 08, all the conventional economists could shout about was a “normalization” of interest rates. At 5.25%, it never made traditional ceilings of 6% for normalized markets before the house of cards caved in.
With payment of interest on reserves, the Fed only needs to move the funds rate higher (along with reserve interest) in order to respond to inflation risks.
I’m not really satisfied with this answer. Paying out interest on reserves will contribute to making the central bank even more insolvent, particularly if its assets are underperforming for whatever reason(longer-dated, toxic waste, foreign currency, etc.)
There was apparently significant pushback against allowing Fed CD’s. That disappointed me, because it was a great way to curb the Fed’s exposure to duration risk.
So the Fed doesn’t need to drain reserves because there’s no longer any extra interest rate leverage from doing that. So it doesn’t need to sell assets to force rates higher. So it doesn’t technically need performing assets. So it doesn’t technically need to be balance sheet solvent.
On a fully technical basis, I agree as far as inflation goes, if we really assume it’s okay for a central bank to go arbitrarily deep in the hole.
I’m a little more worried about handling overseas liabilities of U.S. entities, like Citi’s overseas deposits in the event the whale somehow finally washes up on the beach. But not much.
I’m mostly curious about investor and international perception. Either of those could hypothetically respond to the apparent insolvency by reducing exposure to and investment in the currency, in anticipation of the required recapitalization someday occurring. This is where I see the rubber meeting the road, if indeed it does. And I have no idea whether it does, but my intuition is that it would at some point.
Buiter’s thoughts too, if you haven’t seen them yet.
Enjoy the insights — hope you pick a name and settle down here for awhile.
Ndk,
“Paying out interest on reserves will contribute to making the central bank even more insolvent”
Agree.
“That disappointed me, because it was a great way to curb the Fed’s exposure to duration risk.”
Agree it should be available as an option.
Buiter’s great, because he’s very smart and doesn’t hold back in a wonk mode that seems a little more original than the usual academic overdrive. Perhaps my theme here is a bit in conflict with his views on central bank solvency as well – but I haven’t read his paper in a while so I’ll go back to it.
My only point is that technical insolvency isn’t necessarily an obstruction to the core central bank function of determining the policy short rate. You’ve noted the nature of the qualification yourself in your point above on reserve interest.
As Yves noted just above, this power to set the policy rate on its own is woefully inadequate for resolving the long term issues around monetary policy. We obviously need massive reform on the requirement for a wider scope and more comprehensive set of policy tools and institutions.
On the very last point just now, my subliminal theme to the technical issue is that the best way to view the operational capabilities of a central bank is to view it as one element in a seamless configuration of bank and government balance sheets. This unified view should hold for the issue of solvency as well. I don’t think Buiter’s there yet.
I’ll probably be around with a handle at some point. I’d echo what I saw from one commenter: you clearly have the knowledge and smarts to run your own blog, although I can understand reluctance for other reasons. Still, you also seem to be unusually well organized in terms of just in time link references – like you’re blog ready but in desire dry dock. Anyway, keep on commenting.
Assuming ongoing huge deficits and Treasury debt/gdp ratio going well above 100% then the Fed may be permanently forced to keep interest rates low – as it will not be able to pay down the debt.
Higher interest rates required to control inflation – and the amount of TIPS outstanding – it will have a rod for its own back with that debt alone.
You can’t just construct scenarious while ignoring all aspects of the things you suggest. If CPI Index increases somewhoe to 12% per year, the US Public Debt interest payments would increase by approximately 5 times (given today US Treasury yield is 2.5%). That means about $2 Trillion in interest payments on Debt alone. Do you really think US Government would last much at this level of CPI increases? The bonds would lose a lot of value (80%) and that would kill the balance sheets of all that hold the Treasuries, particularly China and Japan. The US Govt would collapse and so would all the countries whose export oriented economies so dearly depend on USA. You cannot inflate the debt away even theoretically without causing a massive world wide political and economic revolution.
First, we DID have inflation that peaked at over 13% in the 1970s stagflation. And it took Volcker, who was derided in many circles, to wring it out. Many believe he went to the verge of creating a Depression. We are not going to have the will to put the economy back to where it is now to wring out inflation when it starts to rear its ugly head. We don’t have the political will, or civil servants like Volcker.
Second, the Treasury does not refinance 100%, or even close to it, of its debt every year.
Third, the Treasury made various adaptations to reduce its cost of financing in the 1970s. I suggest you review that playbook.
Fourth, Bernanke has indicated that he would purchase long-dated Treasuries to lower long bond rates. There is no reason to think the Fed might not do that in a high inflation scenario. In fact, my German friends remind me that German Bund rates were at 6% in 1923. They were the very last asset to succumb to hyperinflationary pricing.
Fifth, TIPS were issued in limited numbers, and were five or ten years in maturity. I have not looked at the amounts outstanding, but the effective maturity of all TIPS has to be well below ten years. It will take a couple of years for serious inflation to kick in. And CPI is sure to be gamed further to make reported inflation (and TIPS payments) lower.
Jesse and others have said the US must either default on its debt explicitly or default via inflation. We are most certainly not going to default explicitly.
Stocks at various point in time have been seen as an inflation hedge and inflation victim.
The Zimbabwean stock market rose 330,000 % in 2007…
Common shares are a claim on very long-term cash flows, and those, in principle, keep pace with inflation.