0:29:08 … And then the question going forward is, "What’s the trigger?" – Frank Warnock
Doom Transcripts: Index & Guide
Housing Doom is pleased to present complete unauthorized annotated transcript VI.F for the American Enterprise Institute’s December 1, 2009 event "Global Imbalances: The Next Crisis? A Presentation of the No Way Out Conference Series".1 The event site has some further resources including an event summary and both an audio and a video of the proceedings. There is as yet no official transcript.
Table of Contents
[link navigation works best when full article displayed]
- 0:00:00 – Vincent Reinhart intro
- 0:05:25 – Frank Warnock presentation (short preview post)
- 0:31:24 – Desmond Lachman presentation
- 0:49:28 – Panel discussion
- 1:00:40 – Q&A
- [1:30:19] (end)
Vincent Reinhart: [0:00:00] Good afternoon, and in case you were worried, it really is hot in this room. And it’s not just about the world economy or financial markets. But we are, as opposed to the world economy and financial markets, there’s a thermostat that you can turn down, and it should have an effect.
So my name is Vincent Reinhart, I’m a Resident Scholar here at the American Enterprise Institute, and I just have one world for you, … Dubai!
I just wanted to get your attention. I also wanted to establish that capital flows actually do matter, because there’s a general rule of economics, one of the best predictors of financial problems is prior borrowing. It may seem self-evident, but you can’t have a debt crisis unless you borrowed previous to the crisis.
What I find interesting is that’s not actually a feature of most economic models. At least until recently, financial economists didn’t focus on balance sheets. There’s been lots of sophisticated work on the determination of exchange rates, asset prices more generally, risk premiums. But they often didn’t take account of balance sheet measures, or the composition of the balance sheets of households, firms and the government.
I think there’s also been comparable experience at central banks. Most of the models used by central bankers over the past 10 years assumed that there was arbitrage across markets, that you could describe the behaviour of a representative agent, so that you really could reduce the policy problem to the control the short term interest rate. Gross flows didn’t matter, gross positions didn’t matter, there would be strong netting, and in fact, the short-term interest rate encompassed everything you needed to know about financial markets.
And so the policy problem was all about the control of the policy rate.
That’s sort of interesting, because it means that most of what central banks in the advanced economies have done over the last year and a half are outside of the standard models they use. That is, they’re doing quantitative easing, but they can’t quantify what they’re doing.
If you ask how come economists and financial economists have worked with models that don’t look at balance sheets, there’s two reasons. The first is, they’re inelegant. You don’t get to use some of the same fancy math when you have to worry about things like "assets equals liability plus capital." And so some of the initial models of exchange rates and asset prices exactly went to the behaviour of the representative agent, because heterogeneity and gross positions are just very, very hard to handle in the sophisticated mathematics that economists are wont to use.
The second reason why there hasn’t been much focus in modeling in our explanations for the economy on balance sheets is because there haven’t, … there really aren’t much good data. It’s actually hard to gather up information on the exposures of individuals, let alone national economies.
And so that for most of the last century, what economists did when the dealt with quantities was look at net aggregates gotten from, say, cumulating observable flows.
The last decade or so there’s been a change. There’s been a change in part because of very hard work done in measuring capital positions, measuring the balance sheet of the representative of the global investor, measuring the national balance sheet. And one of the people doing that hard work was Frank Warnock, who is now at Darden School of Business at the University of Virginia, and who was a colleague [of Reinhart] for a while at the Federal Reserve Board.
And what Frank is going to do is spend the next 20 or 25 minutes (I’ll call him out at 25 minutes) talking about global imbalances, and giving some background on different views on the problems of global imbalances and explaning why the crisis was or was not related to that issue. And if it wasn’t this crisis, why it might be the next crisis.
After Frank talks, then [0:05:00] my current colleague, Des Lachman will give some remarks for about 15 minutes or so. Then we’ll give a chance up here to exchange any views, if we feel so inclined, and then we’ll take questions from the audience.
So for the next 25 minutes, Frank’s got the floor.
Frank Warnock: Thank-you, Vincent, [slide2 1] and thanks for inviting me. This is on, can you hear me in the back? Good.
The … So what I’ll do for the next 20 minutes is just walk you through a pretty simple story, mostly with pictures and some numbers. None of the complicated math that Vincent mentioned. I gave that up, I think I gave that up with my dissertation.
But my, let’s say, value-added on this particular debate is that I have a reasonable sense of the international capital flows, and the cross-border positions, so I’ll attack this from that perspective.
There’s a lot of different angles you can come from in thinking about global imbalances. My take on it’s going to be from the portfolio side, for the most part.
The … So the plan, [slide 2] quite simply, I’m going to talk about global imbalances, focus on portfolio aspects of global imbalances, talk a little bit about pre-crisis, the buildup to the crisis, briefly on the crisis, and then spend most of my time trying to get a sense of where we might be headed from here. So that will be speculative. I don’t pretend to be able to forecast any better than anybody else in this room, but hopefully the way that I have of laying these things out and presenting it will help you think through some of the issues.
So if we go back to 2004 / 2005 / 2006 there was a lot of writing about global imbalances, [slide 3] and how global imbalances, which, I guess, in a quick definition so that the huge flow of money (so again I think about it from the portfolio side) the huge flow of money coming from China and other places into the US, the huge associated US current account deficits, and some people want to focus … start from the current account deficits and then talk about the flows; other people would want to start from the flows and talk about the current account deficit. It’s a general equilibrium system, and so in some sense it doesn’t matter in which way you start. So in general, these enormous flows coming into the US, the very large US current account deficit, …
So if you go back to 2004 / 2005, a lot of people were calling that the likely cause of the next crisis. So the next crisis was going to be a US external crisis where foreigners all of a sudden changed their preferences, their portfolio preferences, in a way that they would pull out of the US. US bond rates would spike, the dollar would fall, and that was going to be the next crisis.
That view, then, morphed a bit (2005 / 2006 / 2007) as it became clear that that crisis wasn’t occurring but another one was unfolding.
But this discussion of global imbalances as a possible source of the crisis goes back at least 5 years.
As it happened, we did not have that crisis, right? The crisis we had was very different. The question is, going forward, these imbalances are just as severe as they were before going forward. Are we likely to see an external crisis in the US?
And, again, from the portfolio perspective, what we saw over the past 10 years is a very large step-up in foreigners’ positions in the US stuff. [slide 4] So in this case it’s US long-term securities.
Back in 2000, foreigners held about 10 percent of US long-term securities, so bonds and equities. And that increased by June 2008 to almost 20 percent. So these are … this is the kind of stock equivalent, or the portfolio equivalent of the massive capital inflows that the US was experiencing.
You don’t have to be able to read these numbers, [slide 5] it’s … and I’ll post this in a paper. What this table [0:10:00] would tell you if you could read it, … so it goes through the various years, and the amount of foreign holdings in equities and marketable treasuries and government agency bonds and corporate and other debt.
And what you see across the board is very, very sizable increases in these foreign positions, going from 2000 to 2008. So back in 2000, for example, foreigners held 35 percent of the treasury market. By June 2008 it was 61 percent of the treasury market they held, right? So this, … the days of decades ago when we could ignore foreigners’ positions in US securities, especially US treasury bonds, is long gone. If foreigners are holding 61 percent of the treasury market, we clearly have to think about their portfolio preferences and how that … how those preferences might evolve over time.
The substantial foreign accumulation of US securities certainly helped finance the current account deficit. [slide 6] It also helped maintain the US current account deficit. If, without those flows, all else equal, the dollar would have been weaker, it would have been harder to run these large current account deficits. So one could easily argue that not only did the foreign accumulation of US securities help finance the deficit, but it also helped maintain and prolong the current account deficit.
And I would also argue that these sizable inflows into US bonds also helped depress US long rates. [slide 7] I’ve worked … early work from back in 2004 / 2005 with my wife Veronica, trying to actually get at this impact of foreign buying on US long rates … foreign buying of US treasury bonds on US long rates. Clearly there are many other factors keeping long rates down, but for a while, it seemed, and I would argue, that foreign buying was one factor.
Flip side is, if foreigners’ preferences switch, and they decide that they’re not interested in holding 61 percent of the US treasury bond market, it could well be that one would see a spike in long term rates in the US. Again, in general equilibrium, there’d be other buyers to come in, but as a partial effect at least, the direction would be higher long rates.
Associated with this massive buying of US debt securities was a massive increase in international reserves. [slide 8] So this graph goes through August of 2008, and I think we’re all … or many of us are familiar with a picture like this, and this just shows global reserves, international reserves. It doesn’t show which countries they’re coming from, but a lot of that’s going to be China, Japan, emerging Asia, oil producers.
And what we see is a very striking increase going into … up through the middle of 2008.
And we also had, associated with this, and again there’s many drivers of global inflation, but one of them, one could argue, was the massive reserve accumulation. [slide 9] We had a spike in global inflation. This picture goes back 3 decades, so the spike doesn’t look nearly as bad as previously, but it certainly was going up. It was 2 or 3 percent, and then went up to 7 1/2 percent, and there were food price riots in many emerging market economies in 2007 and 2008.
So we had some … pre-crisis, foreigners were piling into US markets, had steadily increasing share of US securities, including almost 2/3rds of all marketable US treasuries. [slide 10] The substantial foreign accumulation helped finance, and helped maintain the large US current account deficits, and helped to depress US long rates. Associated with this we saw massive reserve accumulation, and a fair amount of inflation. So this was kind of in the run-up to the crisis that we had.
Then we had the crisis, [slide 11] but again, it wasn’t necessarily directly about global imbalances, and we can, maybe in the Q&A, talk more about that, but the … while the scene was set for a crisis, an external crisis, that’s not the crisis that we had. We did not have long rates spiking, we did not have the dollar plummeting. In the darkest moments of the crisis, the dollar appreciated, long rates fell, and so … [0:15:00] but the question still remains, going forward, how likely is a US external crisis.
And the way I think about this is, … so one, I take as given, we can debate it, but I take as given that global imbalances is a choice variable. [slide 12] So countries choose to accumulate reserves. Without that, and so we could say, well, that the US consumer is voracious, so US consumption is far too high. True, but if it weren’t the case that countries were acquiring these massive reserves and buying US bonds, US consumption would fall more on US goods than it currently does.
So I come from the perspective this is a choice variable, and if you come from that view, then the question is, "What could cause emerging market governments to give up this arrangement, to stop acquiring the reserves?" And that’s one of the things that I’ll be thinking about going forward.
It’s also the result of choice of global investors. And these global investors are both … so both the US investors and foreign investors, and so another question is, "Has the crisis that we’ve gone through, … has it brought about a change in the preferences of these investors?"
The next set of graphs [slide 13] now go through the latest data, so this is through August of this year.[2009] During the crisis there was a pause in reserve accumulation, for the first time in at least a decade. So we actually had a few months where emerging market economies weren’t acquiring reserves, but that’s changed again. So reserves are … accumulation has resumed, the level of international reserves is surging again.
If we look at inflation, [slide 14] inflation’s actually fallen, as we know. It’s fallen around the world. And so that gives, in my mind, emerging market governments some more leeway to accumulate more reserves, because they don’t have to worry so much right yet about the inflation.
That said, commodity prices have started to rise. So that the graph on the right shows just a spot commodity index, and that’s … it’s nowheres near at the level it was at before the crisis, but it certainly is picking up, as we know.
What else would prompt emerging markets to give up this strategy of acquiring reserves? [slide 15] Here I have a purposely blank slide, because I’m going to make Vincent or Des tell me the answer to this one. [laughter] But a shift to domestic demand, away from export-led growth and to domestic demand … If they were to push for that, they wouldn’t be acquiring large amounts of international reserves at the same time.
I don’t know … I’m not an expert on that sort of information, and from what I read, some people say, "Yes, it is happening," some people say, "No, it’s not happening," so Des or Vincent will tell us the answer on that one.
Now if you take the view from an investor’s perspective, [slide 16] what the US has gone through the past year is … So given that we consider the US a developed country, [slide 17] it’s called a current account reversal. If it were an emerging market we’d call this a sudden stop, [slide 18] and a true sudden stop, not the current vintage of Calvo sudden stops, because then you need a large spike in sovereign debt spreads, but a true sudden stop. That is, capital inflows ceased.
And so we had a sharp improvement in the current account deficit, and that’s in the literature what we call a current account reversal. If you look at the gross flows, and so you … These two lines, one of them is gross inflows, one of them is gross outflows. You don’t have to know which one’s which, because they both fall dramatically. So what we actually saw this past year is a sharp, sharp increase in financial flows into the US.
It’s also the case that US investors repatriated a lot of funds from abroad. So the only thing that … so net inflows fell, but they didn’t plummet, because US investors brought so much money home.
So foreigners pulled out of the US, US investors brought their money home, and this is the act of the foreigners pulling out of the US is a sudden stop, but a true sudden stop in the language of the literature.
And this is … So we can see this in the very broad capital flows data, that there’s [0:20:00] been a kind of seismic shift in the nature, and so in the size, and as I’ll show, in the composition of international capital flows coming into the US.
Now you don’t have to be able to read this, [slide 19] I can walk you through the story. This, and so this will be in the paper.
If you actually just look at the most basic balance of payments presentation in the US, and just go through it line by line (and it’s not that painful), you can tell a pretty coherent story, right? So what we have, and again you don’t have to be able to read these numbers, but what we have is a sharp decrease in the current account deficit (that I showed you in a previous side) that’s come about because imports have fallen more than exports have fallen. They both have fallen, and imports have fallen more. We haven’t seen much of a change in the income balances, that’s just an interesting side note.
And the financial account balance, so the net financial flows into the US, it’s decreased sharply the first half of this year. So we used to have financial inflows of $600 billion per year. The first half … So annualized, the first half came in at only $150 billion. So a sharp, sharp decrease in financial inflows.
And this is … So there’s interesting stuff going on on both sides. So one — US investors used to purchase foreign stuff, about $1 trillion a year. In 2008 it was zero. [slide 20] It literally went from $1 trillion down to zero. And the first half of 2009, it’s … it actually went negative. So they retrenched a little bit more.
And so massive change there, and one question is (and so that supported the dollar) and one question is, "Do we think that that’s going to persist?" Right? So that’s one way of thinking about it.
What are we thinking US investors are going to do? They used to acquire foreign things, less so than one might expect, but they were acquiring foreign securities. They then completely stopped. Completely stopped over the last 18 months. That … You think the dollar is weak now, if US investors weren’t bringing all this money home it would be even weaker. What do we think’s going to happen going forward?
As I’ll get to in a slide or two, I think we’re actually going to see a surge in US investment abroad over the next period, let’s call it.
The other … on the other side, foreign official flows, so the thing that grabs the headline, foreign official flows into the US, or Chinese accumulation, Japanese accumulation, etc., etc., of US bonds, but these foreign official flows actually held up quite well. They changed in nature away from long term stuff to shorter term things like T-bills, right? So they’re not buying … So it used to be the past 5 years more loaded up on the long end, it’s become … the maturities have become much, much shorter during the crisis, but that’s held up.
The private flows into the US, though, has just plummeted. [slide 21] Not only plummeted, but reversed. So there’s actually private outflows. And two asset classes that used to attract the bulk of the inflows into the US, agency bonds and corporate bonds, are … have pretty much fallen off the charts, or they’re not … off the radar, sorry. They’ve fallen off the radar of foreign investors, and foreign investors have turned to be net sellers.
So if you go back 5 years ago, private foreign investors were buying, let’s say, corporate bonds and agency bonds combined, $400 or $500 billion worth per year. In 2008 they sold $185 billion, and in 2009 the selling has continued.
So this … these are two asset classes that foreigners have just not only stayed away from, but actually sold existing positions.
So one can ask, it’s very reasonable to ask, "Have we seen the peak in foreign ownership in US securities?" [slide 22] So this is a … I think this is a very important question for trying to get at whether these global imbalances can persist or not, or when we might see the end of the global imbalances.
We’ve seen striking changes in US financial flows, so we have a true sudden stop. The private flows, as I mentioned, near zero in ‘08, then negative in the first half of this year. Foreign official inflows have held up, but private … foreigners of all types are no longer buying agency bonds or corporate bonds. [0:25:00]
And the only reason that the net financial inflows, the financial account balance, so the only reason that that held up at all is because US investors ceased purchasing foreign securities, and actually brought some money home.
So the two questions, interesting questions, are:
- so have we seen the peak in foreign ownership in US securities? and,
- are zero US outflows likely to persist? … do we really think US investors are going to, when they look at the world, the US included, are going to continue to not purchase foreign securities?
You don’t have to be able to read these numbers. [slide 23] This just adds June 2009 to the previous table, and all you have to know from this, in every single asset class, the share that foreigners have owned has fallen. First time in a decade, and it’s across the board. Foreigners have scaled back their positions in US equities, treasuries, government agencies, corporate and other debt. And so one can ask the question, "Was June 2008 the peak?
Are zero outflows likely to persist?" [slide 24] … So this is from a different paper, and again you don’t have to be able to understand these graphs necessarily, let’s just say … US investors, the share of foreign things in their portfolios has increased a lot in the last decade. And these portfolios, the foreign portfolios of US investors, have performed very, very well. Over the past 3 decades, or 2 decades, beaten global benchmarks, beaten rest-of-the-world benchmarks, MSCI-type benchmarks. And so I think it’s a case that if you think of this crisis, any crisis, as an opportunity to reexamine asset classes, different asset classes, when US investors, and investors all over the world, when they do that reexamination some asset classes are going to fall by the wayside and just aren’t going to be considered any more. Right now, agency bonds is one of those asset classes.
But when US investors get around to thinking very carefully about how their foreign equity portfolios have performed, I think, on average, what they’re going to see is a very attractive asset class. They’ve … The two bars, you can’t see it in this picture but the two bars in that right hand side is a rest-of-the-world benchmark, MSCI benchmark, versus US investors’ actual portfolios, and in 17 out of the last 20 years, US investors’ foreign portfolios beat the benchmarks.
So [they're] doing just fine. They’re not being taken advantage of in foreign markets, their returns are quite stong. And I think that when … as we come through this crisis foreign equities, in particular, are going to look pretty attractive to US investors.
So zero outflows likely to persist? I don’t think so. I think there’s going to be a surge, so where developed countries so-called[ph] a surge in international diversification. And if we were an emerging market, we’d call it "capital flight."
So, to summarize (last slide), [slide 25] the … So we’ve gone through what I’d call a true sudden stop, so there’s a sharp decline in gross inflows into the … financial inflows into the US. And mitigated only by a surge in repatriation. And during this sudden stop there’s been a pretty stiking change in the composition of capital inflows coming into the US. Again, agencies and corporates aren’t seeing any inflows anymore, and even with the treasuries, there’s a move to the short end from the long end.
The foreign official flows have still held up, right? And so this … going back to global imbalances, in part it’s a choice variable on the part of foreign governments. These flows have still held up, so if you take a snapshot right now, you’d say, "Global imbalances are still just as much present as they were 5 years ago, it’s building up again." And then the question going forward is, "What’s the trigger?" Right? And is there a trigger? We didn’t have the trigger before, is there likely to be one going forward?
I would argue that I think that outflows from the US are about to surge, so I think US investors are going to look more seriously at foreign markets.
There’s always the perenial question that I used to ask Vince about:
If you don’t invest in the US … So let’s say that you’re a large player, and you have to park money somewhere, where’s the next best alternative? That’s still a question. If I … When I ask our alumni who manage large sums of money this question, it’s still the case that … So there’s not a cohesive European sovereign debt market, for example, and it’s still the case they [0:30:00] have a hard a hard time answering that.
And so that hasn’t changed. There’s a lot of options. Emerging markets clearly we’ve seen, with the capital controls they’ve put on the past few weeks, either cannot or do not want to take this sort of inflow. European markets, again the sovereign market is a bit splintered, so that’s still a question that I don’t think we have a very good answer to.
And so my bottom line, arguing when it comes to global imbalances, and are they likely to persist: I think there is going to be a reassessment of asset classes. In that reassessment, the US is not going to look all that attractive, and so I would argue that we’re closer to a trigger where portfolio investors (and it could be foreign governments, it could be US investors, it could be private foreign investors) will put an end to the global imbalances.
Vincent Reinhart: Thank-you, Frank.
Our next speaker is Des Lachman, who will also have his own slides, which we’re updating right now. And that is a very inspirational picture of the Darden School. [Warnock's end-title [slide 26] features U Virginia’s Business School]
Frank Warnock: I’ll bring a flag for you.
Vincent Reinhart: … We’ve got our banner … OK, and now we turn to my colleague Desmond Lachman.
Desmond Lachman: Thanks, Vince, for inviting me and thanks, Frank, for your comments. [slide3 1] I’m wanting to talk a bit about the global imbalances and where they might lead us, and I’m wanting to extend it beyond just looking at it from a United States perspective, maybe look at it from the perspective of some of the other countries where there are imbalances.
I should say right at the outset that I’ve generally got very clear views as to what is going to be happening to the economies, but I would say that I approach currencies with a great deal of humility. And I do so particularly at this stage, because I … The way I see the world is as really having to choose between 3 major currencies that all have incredible fundamental problems. And it’s a question of deciding whether the United States, which has got undoubtedly weak external fundamentals, are any weaker than those of the Eurozone, or weaker than Japan. You know, we can discuss that at some length.
So one really doesn’t know which way flows are going to be going, because there’s … it’s an assessment … one’s really got to make an assessment of where’s the crisis likely to be the biggest. And I think that it’s no accident that what you’re seeing right now is a central bank in India deciding to buy gold, not knowing, really, where to park its money. And part of the reason I think gold has got a bid, and it’s likely to continue to have a bid in my view, is … Having studied at Cambridge, which has a strong Keynesian tradition, Keynes referred to gold as "a barbarous relic." But it might be a barbarous relic, but it might be a good investment play. [laughter]
Let me turn now to a few points that I’d like to make about the crisis, and as I say I’m wanting to extend it beyond, … What people normally talk about is talking about the US having external imbalance, China having an external surplus, and that really is the problem at the bilateral level. I think the matter is a little bit more complicated.
Let me just start by saying that I’m of the school that this economic crisis is far from over. [slide 2] I don’t buy that we’re going to get a V-shaped economic recovery. I don’t want to go into that in the greatest of detail, but I would say that you’ve really got a consumer that is beleaguered to say the least.
All I’ve got to do is look at these unemployment numbers. [slide 3] I’m looking not simply at the headline unemployment rate, but the blue line includes those people who have voluntarily … who are being forced to take part-time work because they can’t find full-time work. We’re then talking about an unemployment rate that is now 17 1/2 percent.
So the way in which I see these things is despite massive fiscal stimulus, despite monetary easing, we’ve got 17 1/2 percent, a gap that … the labor market gap is huge, meaning that wages are declining, there’s no income growth. Without income growth, it’s difficult to see how you get consumption growth. Without consumption growth [0:35:00] it’s difficult to see how we’re going to get a V-shaped recovery.
Other matters that concern me is … This [slide 4] is just a chart from the IMF indicating that the banks haven’t yet cleaned up their balance sheets. There’s plenty to go. The loans, the green part are the loan losses that they’ve recognized. There’s plenty more to be recognized, and I’m very fearful of a commercial property market bust, that is in the process right now. We’ve got $500 billion of commercial real estate loans that fall due next year, which is going to be putting downward pressure on prices.
That’s a problem for the regional banks. Every time I read Sheila Bair’s estimate of how many regional banks are going, she’s now up to 550, and I guess I’ve got a George Meany approach to statistics. The official statistics, just multiply by 2 and you get to the right estimate.
So you’re probably going to see a real number of regional banks going, so the United States, I just don’t see that out of the woods.
I indicated that I’m not sure whether you get a dollar crisis, but there are a bunch of indications [slide 5] that would make me not too complacent about whether we could really get a dollar move down. We’re already seeing that as risk comes back, we’re seeing the carry trade coming back into full force, people funding themselves in dollars to buy global assets abroad.
But what you’re getting is you’re getting China indicating that it just doesn’t see the United States doing anything serious about its budget deficit. They’re concerned. They loaded up with treasuries and agencies, and you’re expecting them to just continue to buy that?
India’s buying gold, Moody’s warning the United States of an eventual downgrade, and what we’ve seen since March 9, 2009, is we’ve seen the pace of dollar depreciation accelerate. That the whole thing has reversed, the … the safety haven trade has gone off and we’re now putting on risk, funding it with dollars.
Let me talk about the global payment imbalance problem, [slide 6] and this is really … I think that this is really what’s going to be the focus of 2010. Not so much what is happening to the United States and the China relationship, that’s bad enough, but it’s more going to be a question of what is happening in Europe where, the way I see the external imbalances, is you do have the United States having a large current account deficit. [slide 7]
We’ve seen that slide, we’ve seen an improvement. I would think that at least part of this improvement has to be cyclical. So the United States is still running a sizable current account deficit at a time that its external debt position is sky-high, [slide 8] and it’s got a bad budget and all the rest. So I don’t think that you can take the external current account deficit of the United States off the table quite yet.
This chart, [slide 9] which comes from the IMF, indicates the global payment imbalance problem, I think, in quite a nice way. If you look at 2008, the dark blue line is the United States. And this is as a percentage of world GDP.
But then there’s another big chunk down there, and that’s basically countries like Spain, Portugal, Greece, Ireland, Australia where the deficits, they might not be as large as that of the United States, but whereas the United States has been running current account deficits that are 4 or 5 percent of GDP, countries like Spain have been running current account deficits that are 10 percent of GDP. Ireland, Portugal, the market’s now beginning to focus on Greece, and rightly so, is that these are running huge current account deficits.
Of course what the Europeans are going to tell you is, "This isn’t much [different than] between California and Texas. Why are you looking at these balances?" I just don’t buy that, that they … in their currency union, they really don’t have instruments to get themselves out of their problem.
Looking at the counterparts, what you’ve got is the red part is OPEC, the oil producers. The pink part is basically China and emerging market Asia and other countries that manipulate their currencies. They are running big surpluses. But then we’ve got a big chunk that is Germany. So what we’ve got is we’ve got a situation in Europe where Germany runs the huge surpluses, the Mediterranean rim countries run the big deficits, [0:40:00] and I’m not sure that that is as stable kind of situation that can go on indefinitely. That is going to have to be corrected, and that is a little bit more complicated.
This chart [slide 10] just gives you an indication, which is Spain is the line at the bottom, Germany’s the line at the top. You can see that we’re not talking about small numbers here. Spain was running a current account deficit, the second largest current account deficit in the globe at something like $150 billion before its economy collapsed, and you’ve got a current account contraction for that reason.
The problem I’m not wanting to minimize for one moment is the problem with China. [slide 11] China’s bilateral balances with Europe and the United States — I’m not quite sure what the Chinese are thinking. If they think that they can continue to export at a time that unemployment in the United States is 17 1/2 percent by certain measures, 10 percent by other measures, I think that this looks like a recipe for protectionist backlash unless you correct those imbalances.
What do you do about this? [slide 12] What do you do about imbalances? Well, the economists’ idea, Max Corden would have put it this way, is that 2 things really need be occurring if you’re going to get a optimal correction of imbalances without throwing economies into recession.
The one is what he called expenditure-switching, which means that the exchange rates have to move in the right kind of direction, and the other is expenditure reduction, that countries have to increase– … if they’re in deficit they’ve got to, I think, increase savings or reduce investment to bring their situations into balance, where there’s room for the switching to take place.
So if you look at this just from the point of view of the United States and China, [slide 13] what really should be happening is the dollar should be depreciating against the renminbi, and what you should be getting is you should be getting the Chinese should be increasing their consumption, and the United States should be increasing its savings.
When I look at what’s going on, it’s quite a different story, is that the United States might have been depreciating against other currencies, but it’s not depreciating too much against the Chinese renminbi (I’ll get to that chart in a moment). The more basic point is it doesn’t look like the United States is doing too much about its savings. While household savings is going up because of the crisis, what is occurring is the government is just allowing its budget to balloon.
These numbers [slide 14] are from the Congressional Budget Office, that estimated (this some time ago, around about April of this year) that the United States deficit could be of the order of 13 percent of GDP, but more disturbingly is that even if the economy recovers fully by 2019, the Congressional Budget Office thinks that the US is still going to be running a budget deficit of between and 4 and 6 percent of GDP. And that’s not taking into account health costs, add-ons and the rest.
So the situation on the budget side, I think, is a cause for concern as this chart [slide 15] illustrates. This is a long chart. Any of those of you around about … around in the 19th Century will remember that we never got our public debt quite as high. This is the the largest increase in US public debt in peacetime, which if you were Chinese and accumulating more of these treasuries, you need to worry about.
What I mentioned before is, just in terms of the exchange rate movements, that’s the second point I’d make (the first is the United States doesn’t seem to be taking its public savings too seriously). We can spend our way out of any problem, let our children and grandchildren worry about the debt.
From an adjustment point of view you should be getting concentration on medium-term fiscal consolidation, I don’t see.
But what’s occurring on the exchange rate is also bothersome, [slide 16] that the Chinese since around about June of 2008 have basically pegged their rate to the dollar. That’s the red line. You know they used to, under pressure, allow the currency to move some, but what they’re doing is they’re now pegging their currency to a country’s [0:45:00] currency that is depreciating at a rapid rate. So what it means is the blue line is what’s occurring to China’s currency.
On an effective basis China is depreciating a lot at a time that it’s running massive surpluses. [slide 17] That to me doesn’t look like we’re making much progress in terms of dealing with the US / China bilateral balance.
I’ve just put here, in my view, I don’t think that a dollar crisis would be a picnic. [slide 18] I realize that I haven’t won a Nobel Prize, but Paul Krugman somehow seems to think that we should welcome dollar weakness. And I just think that that is off the wall when you consider, as Frank has told us, that foreigners are owning something like 60 percent of our treasuries. [slide 19] I just don’t think it would be a picnic if we got people moving out of treasuries, driving interest rates higher, seeing the dollar tank. What you’d just be getting is it wouldn’t be a pretty sight on Wall Street.
So I think that you really do have to take the idea of a dollar crisis seriously, that you really don’t want to invite it, you don’t want to talk the dollar down. But my view is, if you don’t like the dollar, where do you go other than gold? There’s only so much gold that you can buy.
So far I’ve really tried to concentrate on the optimistic part of my talk, [laughter] because Europe, [slide 20] I think, is really a train wreck waiting to happen. You know and it’s really a slow-motion train wreck. I should just say from a professional point of view, I used to work on Argentina at some stage, and conceptually, what we’ve got in Europe is not very different from the Argentine story.
Let me explain what I mean by that. What we’ve got is we’ve got countries locked in a fixed currency arrangement, as fixed as can be. They don’t have a currency, they share a currency, yet they haven’t really behaved according to the rules of that currency arrangement.
So what we have [slide 21] is we get a situation where you’ve got the loss of competitiveness of places like Spain and Italy, which are the top two lines. So since the euro’s inception, those countries have increased their labor costs, unit labor costs, by something like 30 percent, whereas Germany, true to form, has reduced its unit labor costs by 10 percent.
So what we’re talking about is we’re talking in a fixed exchange rate arrangement, countries that have lost 40 percent international competitiveness.
How do you regain international competitiveness if you don’t have a currency? Well, the only way you do it is through blood, sweat and tears. Perhaps that was the wrong term (I’ve just spoke to Germany). [laughter] …
But what you’ve really got to do is you really just got to crunch your economy. So you’ve really just got to put them through a wringer, but then that raises a problem with the public finances. [slide 22] So if you just take a look at a country like Spain, Spain is now running public deficits [slide 24] … It used to be running a slight surplus before the crisis, it’s now running deficits at around about 10 / 12 percent of GDP. So if you try to adjust your external imbalance by deflation, what you’re really going to have is you’re going to have a major public finance problem.
The obvious solution, of course, is to devalue currency, but that is very problematic, because what that would automatically mean is you default on your debts.
So basically what’s I think’s going to occur, is you’re going to have real problems in Europe that the European Central Bank will somehow try to paper this over for a while, but it will be a fool’s errand, because they’re not going to be able to solve the basic problem.
I think I’ll end on that upbeat note. [laughter] [slide 23 appears not to have been used]
Vincent Reinhart: So perhaps the best news for Des would be if the Nobel committee starts thinking about for a prize in gloominess. Let me just make a couple of observations and then questions to my co-panelists. And then we’ll open it up more broadly.
Frank, you explained that crises lead to a reexamination of assets classes. And I think that leads me to make three points.
The first is, it’s really important that we get the [0:50:00] right narrative coming out to explain what just happened to us. Because if you think about it, after The Depression, the story that it was an excess of competition, multiple government failures and the need for regulation led to, basically, a three decade aversion to equity markets, which has real consequences for resource allocation.
So I think it underscores the importance of the narrative.
Now with regard to that reexamination of assets classes, one possibility is that foreign governments have concluded that second-hand triple-A exposure to the US dollar just isn’t worth it. And that you can get that second hand exposure either by buying the debt of the GSEs, banking on their implicit guarantee, or you buy corporate securities that are overcollateralized by residential mortgages, whether they’re MBS or a variety of collateralized mortgage or debt obligations.
If that’s the case, if the conclusion is, "Triple-As really ought to be triple-A and not constructed by rocket scientists," how are we going to restart the asset-backed securities market?
And the third observation is that if they’ve reexamined asset classes and decided that emerging markets look good, how are authorities in emerging markets going to deal with that mixed blessing? And that’s a phrase, actually, my wife Carmen and I used as a title of a paper dealing with the mixed blessings of capital flows. And the answer is: you put on capital controls, you raise reserve requirements, you put on transaction taxes.
Are we in an environment going forward as the US economy’s performance diverges from the emerging markets, and those markets look like good destinations for global investors where they may very well respond with more forms of intervention and controls on capital.
And finally, two questions for both guys: How are we going to fund the large US budget deficits? The share in the global portfolio is already high. We’ve seen some resistance at this high level. How do we get what might look like an optimistic prediction that it’s only $700 billion worth of interest service in 5 years if the global investor is not encouraged to continue to add to their holdings?
And the second question is (I think Frank was admirably forthright in saying, "Well this wasn’t the crisis that people were talking about 2 or 3 years ago"). Some people have a second generation explanation of the crisis, which is that, "Well, we told you big global imbalances were a problem. It didn’t work out exactly the way we predicted, but those big global imbalances were keeping US interest rates low. That was inflating the US housing market, and that led to the crisis. So we were right after all!"
Now Mike Dooley, one of the fathers of the Breton Woods II theory, expresses that as, "the prediction that we’d be hit by a meteor, when we were all flooded they said, ‘oh, yeah, told you so!’ "
So a couple of questions, Frank first and then Des.
Frank Warnock: Thanks, Des for the uplifting discussion, and Vince for the questions.
The …
Desmond Lachman: Don’t say you weren’t warned. [laughter]
Frank Warnock: Actually, I expected much worse, so that was good.
… So to the second question, the last question that you asked, Vince, on the global imbalances. And we’ve certainly read a lot recently about people saying exactly as Vince said that, "We warned you about these large imbalances, and look, we did have a crisis."
So if you go back a few years ago, I guess I would say … So my standard line on global imbalances a few years ago was not that they were going to lead to a crisis, it was that if the US was an attractive place to invest, both for US investors and foreign investors, that this isn’t really something that we should be worrying about.
How it then evolved into a crisis, even indirectly, is through the financial system not being able to [0:55:00] allocate funds appropriately.
All right? That’s from my perspective. So we always have the assumption that the money flows in, our financial system is sophisticated enough that it will be able to find the most productive use for these funds.
If that’s a wrong assumption (and it turns out it was a wrong assumption) then sure, then you can go from the global imbalances to our crisis. But there’s a whole lot of things in the middle there that were necessary, that were not directly related to these large inflows.
That said, we certainly could, going forward, have an external crisis. As my comments made clear, and again I try not to make bombastic statements or really kind of stark predictions. But I do think, all else equal, that US assets look a lot less attractive to both the US investors and to foreign investors than they did 5 years ago, and that’s something that will bring the end point of these global imbalances forward, in my opinion.
How to fund large US budget deficits? You might as well take a crack at that one Des. [laughs] As you know, historically either you inflate or you default when they get this big. And so I’m not sure that’s on the table right yet, but that would be my way of saying, "I have no idea."
Desmond Lachman: Let me just say on the last question, your global imbalances and the current crisis, I think that that is just a total cop-out for US policymakers. The fact that you might have had savings coming in from China was no reason why you totally ignored regulation of non-bank mortgage originators that really were in a very important part of the crisis. There’s no reason why you kept short-term interest rates low for too long. Yes it might have made it more difficult to adjust, but I don’t see it as absolving the policymakers from huge mistakes, for allowing bubbles to develop. They’re got instruments, other instuments that they could have used to reduced leverage, to reduce liquidity. So I really just don’t buy the notion that this whole crisis was because we had global imbalances.
Just on the equity market end, asset classes. I’ve been impressed by some estimates just showing that equities as an asset class in the United States has underperformed, on a 10 year basis, fixed income for quite a while. So I’m not sure that equities are quite what they’re cracked up to be, or what the sell-side would explain them to be. I’d also just observe, I’m no great student of the Japanese economy, but my recollection is that in 1989 the Nikkei was at 39,000, and today it’s around about 10,000 or so. So this is something like 20 years later, so I’m just not sure that we should assume that because we’re having a liquidity-driven bull market right now, if the fundamentals are fairly shakey I’m not sure what the future is for the equity market.
On the emerging markets, I totally agree with Vince that it’s rather dramatic. What we’re seeing is we’re seeing the public debt to GDP ratios of Europe, the United States, Japan (well Japan’s at 200 percent, so that’s another story). But they’re all going towards 100 percent if not beyond, whereas if you look at the Brazils of the world, the Russias, the Indias and so on, their public debt to GDP ratio is something like 40 to 50 percent, which it’s just been a complete reversal.
I totally agree with Vince that long term I just don’t see how the US funds its budget deficits, particularly if you think about what happens to entitlement programs. We’ve got the CBO [Congresional Budget Office] telling us that by 2019 we’ll be at something like 80 / 90 percent GDP in terms of public debt to GDP ratio, but the next 20 years things really get out of control. We go up to 300 percent. That clearly is not going to happen, and I think that that’s a little reason why people like the Chinese [1:00:00] are concerned that we might be just trying to inflate our way out of these problems, which I personally don’t think you can do very easily. The inflation has to be a surprise, you really have to get inflation to be at a very high level given the shortness of the maturity of the US debt.
But I mean this is a serious problem. This is something that really should be addressed.
Vincent Reinhart: Thank-you, Des. That may not not be something that Ben Bernanke brings up on Thursday morning as a potential solution to our debt problem, or at least if he wants to be reappointed.
Desmond Lachman: I judge him by his actions, not by his words …
Vincent Reinhart: OK, we’ve got some time for questions, and so a couple of ground rules. The first is, please wait for the microphone, please ask a question, and identify yourself.
Stephen Canner: Thank-you, I’m Stephen Canner from the US Council for International Business. I have a question for each of our speakers, first for Mr. Warnock on your outlook for US investors investing overseas. What’s your take on — Are they chasing another asset bubble? With interest rates so low here, and if you can borrow some money and invest overseas? Are the US investors just chasing another asset bubble?
And then for Mr. Lachman — Yes, consumption has to go down, and saving has to go up, but you didn’t say what the rest of the equation is. Either exports have to go up significantly for job creation or we have to transform the savings into investment. If you’re a businessman and you’re looking at all that uncertainty out there: What is climate change going to cost me? … What is the health care program going to cost me? … Not a whole lot of incentive to transform … reduce consumption. And if consumption is not reduced, therefore it’s 71 percent of GDP, but if it does fall, how do you get it into investment?
Frank Warnock: So on the question of whether US investors are chasing another asset bubble overseas. I can’t say definitively whether they are or are not, but what I can say is that looking at the behavior of US investment abroad, especially in equities, over the past few decades we don’t actually see evidence of momentum type trading, the type of trading that you would think might help create asset bubbles in countries. And also on the downside we don’t see any evidence that they pull out of these markets when they do poorly.
And so they actually say that if you take it on aggregate, looks like very sort of responsible investing. And yes, the returns are quite volatile in some of these markets, but the type of data that I look at, it seems to me that … So what they tend to do is sell past winners, often. So if you look at the whole portfolio they’ll reallocate away from markets that have done well, as opposed buying the past winners, or selling the losers. And so this to me is very responsible type of investing.
That said, if you’re Brazil or some other country on the other side of these flows then, as was pointed out, this could be a real issue. Try to … How to … I wouldn’t want to be a small open economy trying to manage these inflows.
Desmond Lachman: Just in terms of the United States correcting its payment imbalance, I was putting it in terms of savings have to go up, investments got to go down. Or preferably savings got to go up and investment stays high, but savings is a lot more. That would make the room for exports to take place. Exports, though, do have to take place. That that is basically the way in which the adjustment occurs is that the United States needs to export more, import less.
The point I was trying to make is that this is not entirely in the hands of the United States. That basically you are needing to have a coordinated solution to this. So as the United States raises its savings, what you would hope for is that China would be raising its consumption.
Why I’m rather gloomy about that prospect is: When I look at what the Chinese did in terms of their stimulus plan, their stimulus plan was not very much to do with raising the level of consumption, rather what they were doing is they were raising the level of investment, they were raising excess capacity [1:05:00] in a lot of export industries.
The Europeans have just spent a little time with the Chinese worrying about the capacity that they’re building up in steel, in all the sort of products that are going to dump on the global markets.
So that is the reason why I don’t see this glob– … certainly the bilateral balance-of-payments problem with China between China and the United States, China and Europe; it doesn’t look like the Chinese are doing what they are supposed be be doing. They’re not letting their currency appreciate, and what they’re doing is instead of taking structural measures that might increase consumption over time, what they’re doing is they’re adding to capacity, which I think is going to be problematic when that capacity comes on-stream.
Andy Laperriere: Hi. Andy Laperriere with ISI. Question for Desmond. You kind of teased us with a Doomsday scenario in Europe and Spain and such. Could you spell out how you think it turns out?
Desmond Lachman: Yeah, it’s … You know, I don’t think it’s difficult to get the endgame. The endgame is that the euro is not, in my view, the euro is not going to hold. What is difficult is the timing, because basically what’s occurring is that the ECB is financing this, and the ECB can continue to finance these deficits for a long time. But in the end, it’s going to be very much like, in my view it’s going to be very much like the Argentine situation where the United States Treasury and the IMF funded an unsustainable position for a number of years until they realized that the whole thing was unsustainable.
What makes me very pessimistic about Europe is that we’re not talking about a rinky-dinky little country like, you know, some of these Baltic countries, which cost you $10 billion or so to prop them up. We’re talking about a serious country. We’re talking about something like Spain, which is huge. Not only are we talking about a large country like Spain, but the same way that I was talking about Spain, I could be talking about Ireland, I could be talking about Portugal, I could be talking about Greece.
So what I’m saying is the cost of keeping this show going is going to become very large.
The reason that they’ll try to keep printing … the printing press will keep going, why they won’t really want to be facing up to this, is that the euro changing in any way, you know, any members leaving the euro, would be a cataclysmic event.
So the same thing as with Argentina, that they’re just going to be trying to hold the line for a long time, but in my view it’s like King Canute’s trying to hold back the tides. That I just don’t see a solution that … Unless you tell me that Germany is prepared to finance this forever — you know, 10 percent of GDP, deficits in Spain, until the cows come home. Maybe they are, but I … Somehow I think politically something will give.
What will occur is that the Germans will try to insist that Spain reduces its deficits and for Spain to be trying to reduce its deficits in the midst of a recession I think is a fool’s errand. Because what you’ll do is you’ll just be driving the economy further into the ground, opening up the deficits, and you’ll be getting yourself into that kind of trap.
Chow Chen: Yeah, Chow Chen, freelance correspondent. We’ve always heard the talk about foreign exchange reserves of emerging countries, but we never heard of that developed country. So actually, what is foreign exchange reserve, and also what’s the function. And both of you mentioned that to solve this global imbalance is to get emerging countries have a local demand, and I think that’s very important. But the thing is, how do you convince them? And I think that policies is … [unintelligible (noisy mic)] … foreign exchange reserves, and whereas developed countries know how. And to get them to develop their local community. And in this case, they are not just cannot absorb their own product, and also they take some falling import. Thank-you. Is this the first book[ph]? Thank-you.
Frank Warnock: So we, [1:10:00] we usually speak of emerging markets, international reserves, because they’re the large accumulators of these things.
Japan has a lot of foreign reserves as well but I don’t think that they’ve been accumulating foreign reserves since summer of 2004. So up to the summer of 2004 Japan was a major, major acquirer of international reserves, US Treasury bonds to be specific, but mostly we see this in emerging Asia, oil producers and some other countries like that.
… One thing that you said — can the emerging markets import the know-how from the developed countries? I don’t think that’s necessary. I mean, there is the know-how in the emerging markets, so I don’t think that’s … I don’t think a technological transfer is necessary. I don’t think that’s the question.
Another question is — can they actually use their reserves to spur more domestic demand? I guess I didn’t mention it in my talk, but when I had to think about these things, about the large accumulation of reserves back in … when I was Vince’s colleague at the Board, this wasn’t a portfolio decision in any sense by these countries, right? It was a … really the thing that they were trying to optimize, in my mind was, … and this goes back to Dooley’s work, was employment, right? So it’s not a portfolio optimization question. It is, "How do we maximize employment?"
And the question is, "Do they think that they can get enough employment in sectors that would produce for the domestic economy?" If the answer is "yes" then I think that they would be doing it, and they might be doing it, but if the answer is "no" then I think that it’s going to persist.
So from the emerging market government’s perspective I view this optimization problem as much more thinking about employment rather than basis points on their portfolio. And that question … that was my blank slide, right? That I don’t know. Are they going to shift more towards domestic demand? I don’t know the answer to that question.
Vincent Reinhart: Let me point out that in one of your slides when you showed, when did they stop accumulating reserves? They paused briefly in accumulating reserves, precisely when the dollar was appreciating because of flight-to-quality demands. That tells you it was much more about the exchange rate and what that mattered for domestic activity than a portfolio decision.
Frank Warnock: On that point, … When I had to … when I used to forecast these flows into the US, and the foreign official flows, the way I would do it is I would just look at the Fed’s forecast for the dollar. And if that went down a little bit, then I would assume that the foreign governments were going to step in to try to prop it up. And that’s exactly how I wrote down the forecast. I’m not saying my forecasts were good, they might have been, I haven’t looked. But that’s … So fundamentally I think this is an issue about the dollar and about employment rather than about maximizing or optmizing their portfolios.
That said, I think we are at the point where, obviously over the past year or more, these governments have thought much more about these portfolios, in part because the light’s been shined on them, but also because they’ve just become so large that the returns on these portfolios, I think, matter a lot more than they did 5 years ago.
Hiro Watanabe: Thank-you for taking my question. My name is Hiro Watanabe, correspondent, Japanese newspaper Sankei Shimbun. Tonight President Obama is going to announce [inaudible] in Afghanistan, and he will announce additional surge, troops, in Afghanistan.
And the question there is, how much the government pay for that. Historically, the wealth of the United States, deficit you created the external deficit also increase. So I’m going to ask you estimation how much the impact of the cost of war [inaudible] in Afghanistan will have, uncertainty of US fiscal deficit, and also external deficit, and finally the strength of the US dollar. Thank-you.
Desmond Lachman: I really don’t know what the costs are. You know, I only have estimates of the costs, but clearly [1:15:00] if you’re going to have extra expenditures really moving in the wrong direction … All I can say is that the size of the fiscal stimulus package, at something like $800 billion was a lot more than the Pentagon’s budget.
So you’re talking … You’ve got to be talking about relatively small numbers in relation to the size of the problem we’ve got.
Vincent Reinhart: And I guess even if you take the current rule of thumb in DC of $1 million a year per soldier, we are talking about small numbers, given the overall budget, but it does highlight that the inefficiency of the stimulus bill, our … the inefficient way in which we used resources to help financial institutions actually is limiting our alternatives going forward, because we have worked our debt up that much more, which means that we worry more about interest service and we have to worry harder for each additional dollar we add to that debt.
Cesar Williams[ph]: Cesar Williams[ph] with SNU[ph], a Spanish language newswire. I wonder if you could, any of you could comment on the world recovery. I mean, because you have presented these grim outlooks for … the many problems that advanced countries have, and then we have emerging markets recovering, and the question is how long that can last. I mean, if you have emerging markets sort of growing on their own, can that be sustainable or not? And with the fact that you have Mr. Lachman mentioned that increasing capacity in China, you need the markets. So I wonder if you could comment on that: Where do you see the global economy going? Thank-you.
Vincent Reinhart: [off-mic and barely audible] We’ll take the next, final, two more questions and then we’ll go around the table, so right there and …
Steve Drabowsky[ph]: Hi, my name’s Steve Drabowsky[ph] and I work with Cambridge Associates. I had a question about the bond market and the outlook for that. I think Vince tried to kick off that question about the asset-backed securities, but I was wondering if you’ve seen that there’s been a structural change? … And going forward if the demand is still there for anything but triple-A rated treasuries? … and what that means for whether foreign investors will diversify globally or by region.
Bill Marsteller: Thank-you, I’m Bill Marsteller with Export-Import Bank, and if I could I’d like to go back to this issue of US outflows to emerging markets. Mr. Warnock mentioned that they had ceased pretty much entirely, but do you think that there will be a strong rebound from that? And you also mentioned that US investors in this regard acted fairly prudently in not whip-sawing back and forth.
But a couple of things I wonder about that. First of all, if that’s true, they missed a great buying opportunity. I don’t know the exact figures, but a lot of these emerging market equity indexes have just boomed this year, as well as the bond indexes. So I’m wondering if they’re still as prudent as they used to be.
And then secondly, in terms of now a strong rebound in these flows, there may be a feeling that they really missed the big up-tick in the market, and what’s left is not that big compared to some of the risks involved. So I wonder if that rebound will be as strong as you think.
Anders Åslund: Thank-you. Anders Åslund, the Peterson Institute for International Economics. First, for anybody who’s interested, I didn’t hear the word "Dubai." How important is Dubai for the world economy right now. Should we expect contagion or not?
And then, a 3-step question for Desmond: You said gold, but which are the substitutes for gold? One also looks for other things. I presume you will say, "commodities," and if it’s commodities, won’t that squeeze out the economic uptick? And how serious do you look up on that? And isn’t that a strong argument against an expansive monetary policy? In fact will be so to squeeze the growth rather than stimulate it? Thank-you.
Merle Smith[ph]: Merle Smith[ph] in a personal capacity. I was wondering if you could opine on Peter Schiff’s prognostications. He was perhaps one of those fellows that predicted the meteor, and then we had the flood, but he has a rationale for explaining the bear market rally that we’ve seen, the liquidity-driven rally, that sounds … compatible with a lot of what [1:20:00] you’re saying up there as well.
So I wonder if that’s not a little bit better, except that he is, of course, bearish on emerging markets and more bullish, I think, on Europe than the things I’ve been hearing here. But other than that, there’s a lot in common in terms of getting out of dollar-denominated assets and into gold and world receipts[ph].
Vincent Reinhart: So we take this as a few questions for you guys to comment as you feel inclined. First, what is the source of the global recovery going to be? What’s the role of emerging markets as opposed to advanced economies? What about the bond market? Are global investors going to want nothing but US government securities? What’s the next step? How do we recover the … How do we reattract interest into non-govies?
Third, with regard to the investment in emerging market economies, if you could comment, Frank … that would be for Frank about what seems to drive those portfolio flows.
Dubai, Dubai, Dubai! If anybody would like to try to generalize from that experience.
And then lastly, bearish on the emerging markets, more bullish here, try to put it into some perspective at the outlook.
Frank Warnock: So let’s see. I’ll start with the bond markets.
So Vincent asked earlier about the ABS market. You know, for these markets, or for … for these markets to recover, it’s not going to come from foreigners, right? And so the … I think the issue is … And so what’s the way forward? The way forward is transparency, right? And so you can go back to the junk bond crisis, when junk bonds were very, very opaque, to put it mildly. Then they had a crisis, but now they’re a reasonable asset class. And how did that happen? It happened with transparency.
So if there’s enough transparency then outside investors (when I say outside investors I don’t only mean foreigners, but myself, so anybody who’s not on the inside) can feel comfortable investing in these things. And so to me that’s the way forward, right?
If you have … If you shine a bright enough light on these things and there’s enough transparency, then you can hope to attract outside investors, both domestic and foreign.
Until that happens, I don’t think foreigners are going to touch these things for a while. Of course now, … Who knows? Six months from now nobody could … it could be the case that nobody will think about risk at all, right? I mean, it’s amazing how quickly these things turn.
On US investment abroad … So US investors have certainly stepped up their purchases of foreign … first of foreign bonds, as it turned out, now more recently of foreign equities. When I say that they have, on average, over the past few decades, behaved prudently, it doesn’t mean that they get everything right all the time. That’s certainly not the case. But what we don’t see is evidence of the type of herding or of momentum trading that one might … that one hears about, but if you look carefully at the evidence you don’t see it.
And so that … So it could be the case that they are too … a little too late for this rally. That’s not a big concern to me. So it’s actually the case … so that the median international investor from the US is a large institution. It’s not my decisions, it’s not ever Vince’s decisions, it’s some big institutional investor’s decisions. And it’s a case that these foreign portfolios, they’re performance isn’t driven so much by trading. So it’s actually by longer standing positions, right?
And so the month-to-month trading that they do, the reallocating that they do between Country X and Country Y doesn’t impact their performance that much; doesn’t help their performance, doesn’t hurt their performance. Very different from foreigners trading in the US. Foreigners trading in the US, they’re month-to-month trading actually depresses their returns significantly. US investors in their foreign portfolios, this month-to-month reallocations just don’t matter all that much. It really is more long-standing [1:25:00] allocations that’s driving their returns.
Vincent Reinhart: One thing on the list that I forgot to mention for Des. If they’re buying gold, what else do they buy, and what does that matter for recovery? But answer what you’d like, Des.
Desmond Lachman: Let me just say that what I think’s occurring is that markets are riding pretty high on a liquidity wave, and in some sense what they’re doing is they’re premising their actions on the expectation of a V-shaped global recovery.
I don’t buy that we’re going to get a V-shaped global recovery. I’ve mentioned with the United States I think there are real problems all over the show. I’m in Janet Yellen’s camp, from the San Francisco Fed, who’s talking we’ll get an L-shaped recovery with maybe a slight up-slope on the L.
That that is …
Desmond Lachman: … OK … That’s … You’re really not going get at that.
If we look at other countries, if you’re looking at the other major countries, Japan is in real serious trouble with its deflation, with its currency. I’m not sure what the Japanese are doing, allowing their currency to strengthen as much as it is. But that’s really going to kill that economy, it’s an export-based economy. I don’t see Japan providing us with much action.
I’ve mentioned Europe. Europe: Spain used to be the dynamo of Europe, used to produce a lot of Europe’s growth. Spain is in contraction as is the rest of the Mediterranean going to be.
So bottom line is I just don’t see very much of a global recovery. I think there are risks you could get a double-dip in the United States.
So I think that investors are just going to go through it again. When they’re going to go through it I would not hazard a guess. I’ve mentioned that I studied at Cambridge with people who were students of Keynes, who used to say … advise people who were wanting to short the market that markets can stay irrational for longer than you can stay solvent. So I don’t want to go there.
Let me just mention a word or two on Dubai. Dubai, I don’t think, is that big a deal in itself. I think that what you’re talking about is you’re talking about $80 billion more or less of Dubai debt that they’re now saying that it’s a lesser amount, that it’s going to be dealt with (they’re talking about $26 / $30 billion). But I think that that really comes as a shock in a way that might have relevance for Russia.
Dubai World is a company that is majority owned by the government, and the government is now saying that it’s got nothing to do with it in terms of the debt rescheduling, so I think that is sending shudders through some of the other emerging market corporates.
What we also saw is we saw the spreads of places like Greece and Ireland really blow out. Greece is now trading at wider spreads than Turkey, which might have been problematic for Greek pride, but it might be telling you that the market is beginning to get that into its focus.
Lastly just on the question as to where do you go as as safe harbor, I am South African and I recall the advertising campaign that Anglo American Gold used to have, "2000 years of investment history can’t be wrong, buy gold." [laughs]
So I think that gold, platinum and silver have got a different characteristic. If you do buy gold, you’re buying gold because you’re buying it, not that it’s intrinsically got value, but because you expect that other people think that other people are going to be buying it.
You know, that is the safe haven. So that is where you go. People aren’t going to run into other commodities. If my view of the world is right, what we’re going to see is we’re going to see commodities correcting in quite a big way. Oil, baring some supply disruption, oil at $75 / bbl doesn’t make sense if you’re getting a slowdown globally.
And just the last point is, I’m not in the camp that the emerging markets can lead Europe, the United States and Japan out of their problems. They’re too small.
I mean, and China, I’ve just mentioned China’s stimulus package [1:30:00] is very flawed, so … And China’s got bubbles all over the show, so China is very likely not to be accelerating growth, if anything it decelerates in 2010.
Vincent Reinhart: Thank-you everyone, thank-you Des, thank-you Frank and thank-you for attending. That concludes our program. [applause] [1:30:19] (end)
[1]: "Global Imbalances: The Next Crisis? A Presentation of the No Way Out Conference Series", AEI event homepage, December 1, 2009.
[2]: "Global Imbalances: The Crisis That Didn’t Occur … Yet" (PDF Slide Deck), by Frank Warnock, Darden and NBER, December 1, 2009
- Title
- The Plan
- Pre-Crisis
- Pre-crisis, foreigners held a steadily increasing share of U.S. securities…
- …and almost two-thirds (!) of all marketable US Treasurysheld by the public.
- The substantial foreign accumulation of US securities helped finance (and maintain) the US current account deficit…
- …and depressed U.S. long rates.
- Associated with this was a massive increase in international reserves…
- …and a spike in global inflation (and food-price riots in three dozen countries).
- Pre-Crisis
- The crisis
- Going forward
- Any indication EME governments will cease to accumulate reserves?
- What would prompt EME govtsto cease to accumulate reserves? (i) A return of inflation
- What would prompt EME govtsto cease to accumulate reserves? (ii) A shift to domestic demand
- The view from investors’ perspectives
- For a developed country, we’d call this sharp improvement in the current account balance a "current account reversal".
- Were the US an emerging market, the episode would be labeled a "true sudden stop".
- Some striking changes in US BOP: (i) Sharp decrease in CAD as imports fall faster than exports.
- Some striking changes in US BOP: (ii) Net fin’l inflows held up in 2008 because US investors’ flows abroad were zero. Sharp decline in net fin’l inflows in 2009H1.
- Some striking changes in US BOP: (iii) Private flows into the US were near zero in ‘08 and negative in 09H1. FOI inflows held up, but foreigners no longer purchase agency or corpbonds.
- The peak in foreign ownership of US securities?
- Have we seen the peak in foreign ownership of U.S. long-term securities?
- Zero outflows likely to persist?
- Summary
- Title
[3]: "Global Imbalances:The Next Crisis?" (PDF slide deck), by Desmond Lachman, AEI, December 1, 2009.
- Title
- The economic crisis is not over
- Discouraging jump in joblessness
- Realized and Expected Writedowns or Loss Provisions for Banks by Region
- Canaries in the dollar coal mine
- Global Imbalance Problem
- U.S. Current Account
- United States: External debt
- Global Imbalances
- Selected Euro Zone Current Accounts
- China’s Trade Surpluses with United States and European Union
- A Coordinated Solution
- Adjustment is far from complete
- Uncle Sam’s red ink: Annual federal surplus or deficit
- US gross federal debt
- Chinese renminbi
- China balance of payments
- A dollar crisis would be no picnic
- % US Public Debt Held By Foreign Countries
- Strains on the Euro
- Unit wage costs in manufacturing sector
- Selected European Current Account Balances
- Real house price index
- Spain – General government accounts
Anyone who wants the “Cliff Notes” version might want to jump to the end and read Lachman’s summary. Of course, after reading that, you might need to go back to see what his concerns are.
Thanks John. Great job. : )
I think we’re actually going to see a surge in US investment abroad over the next period,..–Vincent Reinhart
This is a not-so-subtle hint that the US dollar will become a vehicle for the carry trade, replacing the Japanese yen.
I’m sorry to be the bearer of bad news, but it is beginning to look as if Bernanke will steer the US economy into a “lost decade” depression, just like the Japanese had.
[...] with which policymakers are containing the global imbalances that the AEI folks were discussing in Sub VI Foxtrot, of which the most general is this [...]