Monday, February 28, 2005

Get ready for some pretty strong milquetoast from Robert Reich in today's New York Times.

Saturday, February 26, 2005

The Washington Post has an interesting article today on the "wide shadow" which China is increasingly casting in East Asia. China's political and economic leadership is of most interest for its regional and global implications.
With stronger economic ties between East Asian countries and China has come a rise in Beijing's political and diplomatic influence, according to a variety of sources in China and the region. Treading softly but casting a big shadow, they say, China has emerged as an active and decisive leader in East Asia, transforming economic and diplomatic relationships across an area long dominated by the United States.
While the article speaks of China's leadership in East Asia writ large, the empirical examples are nearly all from Southeast Asia with a few from the former Soviet Union, and I think this is an important point. While China is seemingly welcomed, if cautiously, as an economic power in southeast Asia and an increasingly important player in central Asian security matters over which the Russians are happy to engage China, things are much more frosty in northeast Asia.

The article mentions China as a much stronger regional leader than Japan, which has been fretting most over Beijing's rise. It says nothing about Taiwan, which is in much the same boat as Japan, nor does it mention South Korea which has its own problems with China and especially China's erstwhile ally in Pyongyang. While China's shadow is rising with some aid in the southeast and central Asia, in the northeast it is far from quiet or welcomed. And that has vast political and economic consequences for both the region and the world.

Friday, February 25, 2005

Yesterday, Brad Setser wrestled with Stephen Jen (a cage match no doubt) and came out saying,
Tis true that most countries in the world would rather not see their currencies appreciate against the dollar.

``It's in nobody's interest for the dollar to fall,'' said Jen. ``The Europeans are clear they don't want to see the dollar fall further, so are the Japanese, and now the other Asian countries are saying it.''

But if nobody's currency appreciates against the dollar, the United States' need for external financing is likely to keep on going up along with the expanding US trade deficit. The real question continues to be "who is willing to finance the US in order to keep their currency from appreciating?"
My guess is that Jen among others is counting on dramatically higher US interest rates -- rather than a dramatically weaker US dollar -- to do the work of cutting US imports and putting the world on the long road to rebalancing.

That being said, Stephen Roach worries today that the Fed is just not up to the task of draining the global liquidity pool which it filled itself.
The issue is not whether the Fed should take the funds rate back to its neutral setting � or even into the restrictive zone if it wishes to cool the economy. That is imperative, in my view. The question is whether the Fed will engineer such a tightening. As much as I hate to say it, I do not think that this Fed has either the courage or the political will to pull off such a maneuver. The logic hinges on my belief that the Fed has thrown its full weight of support behind the Asset Economy � an economy that is built on a false foundation of unsustainably low real interest rates.
The Fed seems to care very little for runaway asset inflation. It's only consumer price inflation they seem to care about, and that is still under control, driven primarily by rising global commodity prices than US consumer strength. From everything Greenspan has said and done since 1997, I have to agree with Roach.

This should tell us all we need to know regarding the right wing's intentions for the future of our pensions.
Privatizers are even having a hard time pretending that they want to strengthen Social Security, not dismantle it. At one of Senator Rick Santorum's recent town-hall meetings promoting privatization, college Republicans began chanting, "Hey hey, ho ho, Social Security's got to go."
Ah, the children are our future.

The revised US GDP numbers out today put the exclamation point on 2004. They don't change the massive relative (not to mention absolute) increase in the US current account deficit in 2004:IV, however.

Last month I took a stab at estimating the fourth quarter CA deficit as a percentage of GDP and came up with -6.2%. With these more robust GDP numbers in, the estimate doesn't change at all. While GDP was revised up, the December trade deficit came in larger than I had thought. With a CA deficit of approximately -$185bn for the quarter -- 63% of total exports -- the US continues on a steep steep descent into the netherworld of international financial relations.

Thursday, February 24, 2005

Over the course of 800 words, Tom Friedman demonstrates today that he has absolutely nothing to say on the precarious position of the dollar which a hundred other people haven't said already. He ends with this gem of wisdom:
As I said, usually the markets do it in an orderly way - except when they don't.
Thus I add, "a hundred other people haven't said already and better".

Wednesday, February 23, 2005

The US Bureau of Labor Statistics reports today that core consumer inflation rose 0.2% in January. Is this good news, or bad news?

The markets clearly thought it was the former.
Excluding volatile food and energy costs, the Consumer Price Index rose 0.2 percent for a fourth straight month in January, the Labor Department said.

Wall Street economists had expected a 0.2 percent rise in the CPI, both overall and excluding food and energy, but traders had braced for larger gains after a report on Friday showed a big pickup in core producer prices.

The tame consumer price report helped allay concerns the Federal Reserve could step up its so-far "measured" campaign of interest-rate rises to keep inflation in check.
That being said, annual core consumer inflation is now at 2.3%, the highest level since August 2002. This all seems to be driven, however, not by too many dollars chasing too few goods, but by a relentless rise in producer prices. Thankfully Kash over at AngryBear has done the graphic work for me.



Note the closing gap between core CPI and core PPI since mid-2003. Since 2004 the inflation rate at the consumer level has been nearly equal to that at the wholesale level, and now we see wholesale inflation actually surpassing consumer inflation.

And no wonder. Average real hourly earnings (in 1982 dollars) in January were stuck at $8.23, stagnant for a year and -1.0% from their recent high in November 2003. Average real weekly earnings (in 1982 dollars) fell 0.2% in January and were -1.2% from November 2003. Retailers have little pricing power, and of late are having trouble even passing their own rising costs on to consumers. With stagnant real wages (and outright falling wages among production workers), the Fed clearly has to be wary of raising interest rates too far too fast, cutting the consumer off from his only source of growing consumer power -- debt.

No sooner did the Koreans start a brush fire in the Dollar Bloc National Forest than a five alarm was sounded with brigades from Tokyo, Seoul and Taipei rushing to the scene to stamp it out.
The dollar advanced in Europe after Japan's Ministry of Finance and South Korea's central bank said they have no plans to reduce U.S. currency holdings. Taiwan's central bank said it hasn't been selling dollars.

The announcements by Japan, Korea and Taiwan, accounting for three of the world's four largest currency reserves, came a day after the Bank of Korea sparked the biggest drop in the dollar against the euro in more than six months by saying it planned to change the composition of its holdings. The three central banks have a combined total of $1.26 trillion in reserves.

``They're trying to put out the fires caused by the comments on diversification yesterday,'' said Toshi Honda, a currency strategist in London at Mizuho Corporate Bank, a unit of Japan's biggest lender. ``Today's denials are having an impact and we're seeing the dollar rebound.'' . . .

Masatsugu Asakawa, director of the foreign exchange markets division at the Ministry of Finance, said Japan has no plans to diversify its reserves. ``At this stage, we don't have such plans'' to diversify reserves, Asakawa told Bloomberg at the ministry in Tokyo.

Taiwan's central bank said in an e-mailed press release in Taipei that it hasn't been selling dollars.

The Bank of Korea's press release today followed the won's appreciation to more than 1,000 against the dollar for the first time since November 1997. ``The Bank of Korea will not change the portfolio of currencies in its reserves due to short-term market factors,'' the bank said.
Yesterday I asked "How long can Korea stand the pain?". It looks like the answer is "about 24 hours".

Tuesday, February 22, 2005

Gosh, it seems like just last month oil prices were around $42/barrel. Oh, that was just last month!

That was then; this is now.
Crude oil surged above $51 a barrel in New York to the highest price in almost four months, as colder- than-normal weather in the U.S. and Europe raised demand. . . .

``The colder weather, particularly in Europe, is pushing us higher,'' said Tom Bentz, an oil broker at BNP Paribas Commodity Futures Inc. in New York. ``The strength of the euro against the dollar is also lending strength to the market.''

Crude oil for March delivery rose $2.80, or 5.8 percent, to $51.15 a barrel on the New York Mercantile Exchange, the highest closing price since Oct. 29 and biggest one-day gain since June 1. Futures are up 44 percent from a year ago. . . .

``There's no excess capacity to ease any potential supply disruptions,'' said Rick Mueller, an analyst with Energy Security Analysis Inc. in Wakefield, Massachusetts. ``Chinese demand is growing faster then was forecast and oil producers such as Iraq are not stable.''
Well, at least the Europeans won't be hit quite so hard, what with the euro rising 1.2% today and sterling up 0.8%.

In October 2004 the NYMEX had >$50/barrel oil for 20 straight days. We'll see if February-March 2005 can give that a run for its money.

And I must say, I'm rather put off with this sudden end to spring here in London -- well, at least it sure looked like spring to this guy from the Northeast. When I arrived three weeks ago the temperature was in the 50s. Now it's highs in the mid-30s, snow flurries every day, and damned windy. I want my springtime back!

It appears that Alan Greenspan's commitment to predictability and a massive early warning system to the market has bitten him right in the ass.
The Fed has raised its target interest rate six times since June 30, intending to prevent the U.S. economy from overheating later this year. Instead, the increases are having the opposite effect: They're spurring the economy, not reining it in. . . .

The unexpected booster shot creates a risk that easy money will spur growth, which in turn may accelerate inflation, Richard Berner, chief U.S. economist at Morgan Stanley in New York, said in an interview. Faster inflation is the very thing the Fed wanted to head off with higher interest rates.

Keeping inflation at bay would mean ``short rates are going to have to go up considerably,'' Berner said.

Among signs suggesting the rate increases haven't damped consumer or corporate spending: Bank lending for commercial and industrial loans surged 6.6 percent since May 5, the month before the Fed began tightening. Mergers and acquisitions in this year's first six weeks reached the fastest pace since 2000. Housing starts unexpectedly rose 4.7 percent in January to a 21-year high after a 14 percent surge in December. The 30-year fixed-rate mortgage two weeks ago dropped to a 10-month low of 5.48 percent.

``It's an ideal time to put money to work,'' Paul Beard, treasurer at Sparks, Maryland-based McCormick & Co. Inc., the world's largest spice company, said in an interview. ``The feeling is that rates are going to continue to rise.''
The implication here, of course, is that the market can see well into the future that Greenspan et al. will slowly, gradually and predictably raise the federal funds rate in measured 25 basis point steps for the near-term and thus are keen to borrow like mad now so as to lock in the low rates. Plus, global liquidity means the carry trade is only growing more attractive. Just because Uncle Alan says the party's over doesn't mean it's over at all.

If Andy Xie of Morgan Stanley is right, the Koreans are going to have one hell of a time keeping the won down against the renminbi -- and the dollar -- this year.
The current wave of excitement centers on Korea. When the Korean market was doing well late last year, many international investors did not follow. Almost all money managers are now believers in Korea now. Most money managers believe in a strong recovery in Korea's domestic demand and the rest believe in interest rates declining. The same arguments explaining Korea's problems have come back. For example, the high level of household debt is just a data problem. Everyone seems to have a good reason to be in Korea.

Korea is just the latest example of a liquidity bubble touching a market. A liquidity bubble needs a focal point to turn into higher asset prices. In my view, Korea is serving this purpose now. The changes in domestic funds flow due to government policies drove the market last year. The momentum sucked in retail investors and became stronger. The international investors are just jumping on this bandwagon.
We already know that Korea has battled mightily against won appreciation over the past two years, with the Bank of Korea's foreign reserves growing 27% since January 2004 and a stunning 62% since January 2003. And yet the won continues to rise. In early April 2003 the dollar bought around 1260 won; now it buys less than 1030 won, a nearly 20% appreciation. Over the same period the yen has gone up 13% and the Taiwanese dollar up around 10%.

While Japan and China -- for different reasons -- have the ability to eat and eat and eat US assets, Korea is a much smaller player which has already gorged itself on dollar securities to little avail. Might Korea be an important weak spot in the East Asian dollar bloc? If Andy Xie is right, we may find out in the ensuing months.

UPDATE: No sooner had I published this posting when I ran across this story in Bloomberg today. It appears things may be moving faster than either Xie or I had imagined.
South Korea's central bank, which has a total $200 billion in reserves, said in a report to a parliamentary committee on Feb. 18 that it will increase investments in assets denominated in currencies such as the Australian and Canadian dollars. Korean investors, including the central bank, are the fifth-biggest foreign holders of U.S. Treasuries.

``Support for the dollar is quickly disappearing,'' said Kenichiro Ikezawa, who manages $1 billion in overseas debt at Daiwa SB Investments in Tokyo. ``This Korean story is having quite an impact because it feeds into suspicion that others are also seeking to cut their exposure to the dollar.'' . . .

The report, distributed to members of the parliament's finance and economy committee in advance of a debate scheduled for Feb. 24, also said the bank will expand investments into assets with lower credit ratings than the South Korean government. . . .

``South Korea wants to start picking up higher yields so that includes moves in to the Australian currency and sterling, and they'll be buying government bonds,'' said Austin.
UPDATE 2: As expected, the Korean won shot up today on news that the Bank of Korea plans on pulling back from the dollar bar. As of 4:37pm EST according to Oanda, the won is up 1.2% over yesterday versus the dollar/renminbi, 1.1% versus the yen, and 0.7% versus the Taiwan dollar. Now the real interesting part comes. How long can Korea stand the pain?

Monday, February 21, 2005

The recent �good news� for the US current account � if you can call financing CA deficits well over 6% of GDP � is political rather than narrowly economic: the East Asians [1] can�t get along and [2] show no prospects of getting along much in the future.

China issued a stiff protest Sunday over an updated U.S.-Japanese strategic agreement, saying its reference to Taiwan violates China's national sovereignty and its criticism of China's military buildup is "untenable."

The complaint, issued by the Foreign Ministry, reflected deep concern in the Beijing government over Japan's evolving decision to lean toward closer security cooperation with the United States in East Asia, including Taiwan. Although Japan has not spelled out what military assistance it might provide, to Chinese ears the accord sounded like a promise to help the United States defend Taiwan in the event of war. . . .

The revised U.S.-Japanese strategic understanding, issued Saturday after a meeting of Secretary of State Condoleezza Rice and Defense Secretary Donald Rumsfeld with their Japanese counterparts, for the first time included security in the area around Taiwan as a "common strategic objective" shared by Japan and the United States. This was described by U.S. officials as a new element in a close military association that dates from World War II.

In addition, the U.S.-Japanese statement called attention to China's rapid military modernization program, calling it a matter of concern, and urged Beijing to be more transparent in its military planning and weapons procurement. "While we should maintain good relations with China, we must also pay attention to its military moves," Japanese Defense Agency Director Yoshimori Ono was quoted as saying by the Kyoto News Service. . . .

North Korea also bristled at the U.S.-Japanese understanding, which expressed deep concern over North Korea's refusal to continue negotiations on its declared nuclear weapons arsenal. The Pyongyang government, through its KCNA news service, said Japan's defense policy changes amount to a plot to "reinvade" -- a reference to Japan's World War II occupation of Korea -- and showed Japan was joining Washington's "vicious, hostile policy" toward North Korea.
It looks like the US is stirring the pot this weekend in all the right ways, bringing Japan, Taiwan and Korea (ROK) closer to it and pushing them further away from China and North Korea. While China�s positive relationship with the US is primarily economic, the other three East Asian Big Eaters of dollar denominated assets � Japan, Taiwan and Korea in that order � all depend on the US for more than just markets. They are all heavily dependent on the US for military security and all desperately afraid of China.

Japan continues to build its foreign reserves. As recently as February 2002 the Bank of Japan held �only� �36.5 trillion in foreign currency assets, but beginning in March the BOJ entered into a new asset building regime. On a twelve-month cycle beginning in March and ending in February of the next year, the BOJ builds and builds reserves, drawing down in March and then building consistently again until February of the third year, and so on and so on. From March 2002 to February 2003, the BOJ built its reserves from �41.8 trillion to �43.0 trillion; from March 2003 to February 2004, �42.1 trillion to �43.5 trillion; and most recently from March 2004 to January 2005 (latest data available), �41.7 trillion to �44.4 trillion. Thus January 2005 stands 2.5% larger than January 2004 and 3.9% larger than January 2003.

That�s nothing, of course, in comparison to total Japanese purchases including the BOJ and �private� investors. Altogether Japan is amassing US treasuries at a 29% clip from December 2003 to December 2004 and 46% from December 2002 to December 2003. I put private in quotes because the Japanese government has a long and successful track record of pressing Japanese banks and insurance companies into buying US assets, even in the face of marked exchange rate risk.

Taiwan�s Central Bank of China continues at a healthy build-up rate as well. At the end of January 2005 the CBC had $242.7bn in reserves, 12.9% higher than January 2004 and 47% higher than January 2003. Finally, the Bank of Korea, which at the end of January 2005 had $199.7bn in official reserves, 27% larger than January 2004 and a stunning 62% larger than January 2003.

Brad Setser rightly notes that the Koreans don�t like being forced into amassing ever larger numbers of dollar reserves in order to keep the won down. In fact, they�re working the hardest of the three, but surely the Japanese and the Taiwanese feel the same way. Unfortunately for them all, as long as China is unwilling to dramatically alter the peg and the US is unwilling to restrain its demand for more capital inflows, what can these three do? They�re caught between the Chinese Scylla and the American Charybdis.

Friday, February 18, 2005

Back on January 19, Brad Setser warned us to "Prepare for the 50 year Treasury bond ...", accompanied with the claim
No way any private investor would fund a project with such an uncertain long-term payoff -- at least not without a government guarantee. Imagine the prospectus. We have no clue what the world will look like in 2055, but it is safe to assume it won't look much like what we say it will look like �
Well, it looks like the French are going to put Brad's words to the test.
France on Friday announced it would became the first Group of Seven industrialised country to issue 50-year bonds. . . .

France�s decision to go ahead with the ultra long bond could sway other eurozone governments to follow suit. Germany and the UK have said they are considering whether to begin issuing ever longer-dated bonds. Currently, 30-year bonds form the outer end of the benchmark yield curve . . .

Yields on long bonds have recently fallen sharply, making this an opportune time to issue such paper.
Clearly with long bond prices so low, governments are looking to lock in these prices. But who is going to buy a 50-year bond? The FT article seems to suggest that pension funds and insurance companies will be the primary market.

Do I hear offers on a 75-year bond? How about 100? It seems the world is convinced -- or France is convinced that the world is convinced -- that inflation is gone forever. A mighty risky assumption indeed.

Thursday, February 17, 2005

Japan will remain desperately dependent on exports for the foreseeable future.
Consumer spending fell 0.3 percent in the fourth quarter. The decline reduced economic growth by 0.2 percentage point.

Spending has faltered as companies hire more part-time workers, who typically earn less and receive fewer benefits. Wages have fallen for 43 of the past 46 months, and the full-time labor force contracted for the seventh straight year in 2004.

Government officials including Finance Minister Sadakazu Tanigaki and Economic and Fiscal Policy Minister Heizo Takenaka said yesterday's report hadn't changed their view that Japan's economy was recovering.

Tanigaki said the contraction won't change plans for spending cuts and tax increases to curb the world's largest public debt. Some economists say those plans might further crimp the consumer spending that accounts for half the economy.

On Wednesday, Andy Xie of Morgan Stanley summed up the current global financial condition with his missive "Free Money Reigns Supreme".
Asian interest rates have barely budged since the US Federal Reserve began to raise its policy rate. The enthusiasm of global investors towards Asian growth has kept capital inflow strong despite the rising Fed funds rate. The capital inflow has kept Asian interest rates low, which supports booming Asian growth. This, in turn, validates the global enthusiasm towards Asia, which keeps the funds coming. The fairytale continues.

Asia, in particular China, appears to be experiencing the biggest liquidity bubble in its history. The hot money inflow totaled US$656 billion in 2003�04, which has made money cheaper in Asia than in the US. The hot money turns into demand, primarily through property speculation. . . .

The axis between the Fed and China has created the current bubble, in my view: The Fed keeps money supply loose, and China keeps inflation down. The excessive liquidity pumps up property prices in the US, which keeps US consumption strong, which, in turn, keeps China�s exports strong, in turn keeping China�s investment strong, which finally keeps commodity prices high
Xie contends that China is the very heart of the global liquidity bubble, but it's too bad he didn't include Japan in his comments. Granted, hot money is hardly flowing into sluggish Japan, but the BOJ plans not only to keep interest rates at zero percent (although persistent Japanese deflation makes real rates slightly positive) but also
"Expect the BoJ to maintain the current reserve target range of Y30,000bn to Y35,000bn for the foreseeable future.� This target range floods the markets with liquidity.
If Japanese deflation comes to an end, as recent trends suggest, real rates will fall in Japan, too.

Any college freshman sitting through Introduction to World Politics could have seen this one coming a mile away. Or anybody up on their Arab proverbs such as "the enemy of my enemy is my friend".

Syria and Iran, both condemned by the Bush administration for their links to terrorism, announced yesterday that they are forming a united front to deal with potential threats.

"In view of the special conditions faced by Syria, Iran will transfer its experience, especially concerning sanctions, to Syria," said Iranian First Vice President Mohammad Reza Aref after a meeting in Tehran with Syrian Prime Minister Mohammed Naji Otri. "At this sensitive point, the two countries require a united front due to numerous challenges." He did not elaborate.
The only real surprise is that it took nearly two years after the invasion of Iraq for Iran and Syria to formally tie the knot. Even though Syria is a secular Ba'athist dictatorship and Iran is a Shi'ia theocracy, it's amazing what friendships can form when the same guy has you both in his crosshairs with 130,000 troops hunkered down next door.

Tuesday, February 15, 2005

Sorry to say that I'm not going to be able today to post Part II of my comments on Brad Setser's and Nouriel Roubini's latest paper on financing the US current account deficit. I'll give you a little insight, however -- the political success of Wal-Mart tells an important part of the story.

I'm traveling to Bristol on Wednesday to give a talk, so I might not be blogging tomorrow -- we'll see. If not then, we'll get together Thursday.

In 2004, real compensation of US employees rose 3.0% while real wages and salaries rose 2.5% per the National Income and Product Accounts Tables. At the same time, real personal consumption expenditures rose 3.9%.

And it looks as if 2005 is off again to the races, where consumption always wins and labor income always shows.

U.S. retail sales dipped 0.3 percent in January, as expected, as automobile sales fell sharply, but purchases outside the volatile car sector gained a healthy 0.6 percent, a government report showed on Tuesday.

While the drop in overall sales was the weakest performance in the Commerce Department's retail sales measure since a matching 0.3 percent decline in August, the gain outside of autos surpassed Wall Street expectations for a 0.4 percent climb and marked the strongest monthly rise since October.
Thank Alan Greenspan and the Asian central banks for that housing bubble keeping the American consumer, and thus the US economy, afloat.

The TIC (Treasury International Capital) data for December is in, and it looks like another month -- and another year -- of massive capital flows into the United States.
Net foreign purchases of both domestic and foreign long-term securities from U.S. residents were $61.3 billion in December compared with $89.3 billion in November. Net foreign purchases of long-term securities were $821.8 billion in 2004 as compared to $683.6 billion during 2003.
The October scare, in which long-term flows totaled a mere $46.9bn, seems like a distant memory now. For the fourth quarter, the US trade balance (SA) hit -$171.8bn. The NSA figures are probably a few billion more in the hole since the goods trade balance (NSA) for 2004:IV stands at -$186.0bn and the US routinely runs about a $4bn services surplus every month. Nonetheless, long-term capital flows (NSA) into the US over the same period totaled $197.5bn and thus easily covered the trade deficit.

Foreigners have dramatically shifted their investments as the year worn on. Of the $82.9bn in long-term securities purchased in December, a mere $8.4bn, or 10.1%, went into treasuries. On the year, foreigners purchased $356.7bn in treasuries with 70% of that in the first half of 2004.

Of late, foreign capital and foreign central banks have hungered for US corporate and agency bonds instead. For the year they bought $300.8bn of the former and $232.7bn of the later. This second figure is particularly remarkable, 51% higher than 2003. As 2004 ended, the agency bond purchases became a torrent, with each month surpassing $20bn purchased and with 33% of the total coming in that last quarter.

As long as the US has a housing bubble to sell to foreign capital and central bankers, these gargantuan trade deficit can be financed 'till the cows come home. But when they finally do come home, I pity that house.

Monday, February 14, 2005

I found time this weekend to read Nouriel Roubini's and Brad Setser�s latest paper, "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006", and true to the billing, it was a provocative read indeed. I continue to be skeptical of their basic argument, however, that Asian financing of the US current account deficit (calling it "Bretton Woods 2" gives this arrangement far more institutional credibility and historical weight than it deserves) is on shaky ground. For political reasons most of all, I see the Asian-American balance of financial terror pivoting merrily along for the foreseeable future.

Here is the money line from the paper (page 3):
This paper argues that the current renminbi-dollar standard is not stable: the scale of the financing required to sustain US current account deficits is increasing faster than the willingness of the world�s central banks to continue to build up their dollar reserves.
That indeed is the rub after all, isn�t it? Can the Asians � and that includes far more countries than just China � keep up with the ever-growing US current account deficit? And will they continue to want to do so in the face of the mounting costs? The reasons R&S say the Asians won�t keep up the necessary pace basically boil down, on my reading, to six basic factors, three on the Asian side and three on the US side.

Today I�ll address the assumptions underlying the Asian sources of instability; tomorrow it�s the US.

On my reading of the paper, on the Asian side we have three basic sources of instability in the contemporary Asian-American balance of financial terror:
  1. Capital losses due to inevitable revaluation;
  2. Chinese inflation and associated asset bubbles;
  3. Inability of Japan to do it alone.
For each of these contradictions in the current arrangement to provoke a crisis, R&S rely upon (as of course everyone must) several fundamental assumptions which I find less than convincing. If the assumptions are flawed, the crisis prediction is flawed as well.

Capital losses

The threat of massive capital losses from unavoidable future revaluation of the renminbi as well as other Asian currencies looms large in R&S's analysis. However, as I've said before, these capital losses [1] may be seen as simply the acceptable costs of the system which pays other more valuable dividends; and [2] are only realized in the event of currency conversion from dollars to the local currency.

First, China among others are already experiencing significant losses in open market operations, losing 15-20bn renminbi in 2004. R&S's estimations of huge future capital losses (e.g. 20% of Chinese GDP by 2008) assumes an immediate shift in the currency regime rather than its likely gradual evolution. I'm not sure, also, whether R&S incorporate comparative inflation rates in China and the US. Higher inflation in China than the US (all but inevitable) means lower capital losses in the event of revaluation. Moreover, Japan has long suffered such losses more or less willingly as the costs of maintaining access to the US market.

Second, it may be that the East Asians do not convert their dollars into local currency and suffer high capital losses. China in particular does not fully sterilize and thus is not issuing as much local currency debt to soak up inflowing dollars. Japan doesn't sterilize at all. Both countries could use central bank dollars to loan to private firms looking to make investments in/purchases of oil (still priced in dollars), US corporations, US mineral deposits, US agricultural land, US golf courses, whatever. We already know that all the East Asian banks have accumulated reserves far in excess of what they "need" to defend their currencies. So why not simply keep many of those dollars in dollar form and buy US real assets with them?

Chinese inflation and asset bubbles

Since China does only limited sterilization, the build-up of reserves also builds up the Chinese money supply which in turn stokes inflation and speculative investment and asset bubbles (e.g. Shanghai real estate).

A bubble pop in China would indeed be a serious crisis, both for the global economy and the Chinese Communist Party. However, the bosses in Beijing have been taking measures to address this problem which seem to be working, if not totally effectually at least passingly so. Administrative measures to limit loans have been "draconian" by some estimates. The central bank has also raised interest rates and reserve requirements for banks, both of which have obstructed the growing money supply flowing into speculative investment. Plus, China uses capital controls on inflows, addressing hot money trying to take advantage of higher Chinese interest rates. None of this is perfect, of course, but it can probably continue on for some time.

In addition, if China is going to grow at 9% a year, it will need a money supply growing at a rather healthy clip. How fast a clip? That is the question -- but don't ask it of me. I'm a lowly political economist who never built a single model in graduate school.

Japan can't do it alone

If China pulls the trigger on the balance of financial terror, R&S argue that Japan is not enough to keep the thing afloat. That being said, Japan is a major player in the entire system and one largely (although not wholly) neglected in R&S's paper. Moreover, Taiwan and Korea, the #3 and #4 largest reserve holders in the world, must be part of any equation. These four countries move as a bloc and will continue to do so, looking to China for signals as to which direction and how quickly. Look at Korea's attempt to defect from supporting the dollar in 2004 and its quick scurry back to the pack as the won rose dramatically. This is not to mention the continuing security dependence of Japan, Taiwan and Korea on the United States which surely plays a part in their decisions on whether to eat up US assets or not.

Now if Bush truly blows the budget out of orbit with his crazy Social Security privatization scheme, the US may be asking for more than anybody is willing to choke down. But an analysis of the US side of the story will have to wait until tomorrow.

In April 2003, Donald Rumsfeld said any impression that the US harbored interests in establishing permanent military bases in Iraq was "inaccurate and unfortunate", also calling the belief among some that the US would use Iraq military bases well after the period of occupation as "flat false".

One wonders if credulity is being stretched thin yet again in light of this news.
The Bush administration has been flying surveillance drones over Iran for nearly a year to seek evidence of nuclear weapons programs and detect weaknesses in air defenses, according to three U.S. officials with detailed knowledge of the secret effort.

The small, pilotless planes, penetrating Iranian airspace from U.S. military facilities in Iraq, use radar, video, still photography and air filters designed to pick up traces of nuclear activity to gather information that is not accessible by satellites, the officials said. . . .

A former U.S. official with direct knowledge of earlier phases of the operation said the U.S. intelligence community began using Iraq as a base to spy on Iran shortly after taking Baghdad in early April 2003.
One also has to wonder how long the Russians will sit by and allow the United States to gobble up every country on its borders. It sat by helplessly as the West absorbed all the former Soviet bloc states of Eastern Europe as well as the Baltic states, and then was forced to suffer US bases in Pakistan and Uzbekistan as well as US occupation of bordering Afghanistan and nearby Iraq. US pressure on Iran, however, may finally be met. As the Washington Post article contines,
In late December, Iranians living along the Caspian Sea and on the Iraq border began reporting sightings of red flashes in the sky, streaks of green and blue, and low, racing lights that disappeared moments after being spotted. The Iranian space agency was called in to investigate, astronomy experts were consulted, and an agreement was quickly signed with Russian officials eager to learn more about the phenomena.
The Russian relationship with Iran may be something like the Chinese relationship with North Korea. Little love lost between the major power and the troublesome nuclear wannabe, yet neither interested in allowing the United States to take out the offending regime and install another client.

A delicate situation -- and we know that the Bush administration has as light a touch as a rutting bull moose. So, when does the bombing begin?

Saturday, February 12, 2005

Here is a lighthearted topic for the weekend, one of the most pressing questions I've generated since arriving in London last week:
Why is English yoghurt so damned much better than American yogurt?
Now I don't think it's just the extra 'h' in the UK variety. While US yogurt -- especially that Dannon "fruit on the bottom" kind -- tastes like partial soy curd on top of a layer of jelly, the yoghurt I've had so far in the UK is exceptionally creamy and the fruit tastes like you could have picked it out of your backyard that morning. Are those cows from Devonshire eating better grass? Less rBGH? And how about those berries?

I wonder if I can smuggle some UK yoghurt back home in the luggage . . .

Friday, February 11, 2005

By now you've already heard that the US monthly trade balance for December came in at its second largest tally of all time
The U.S. Census Bureau and the U.S. Bureau of Economic Analysis, through the Department of Commerce, announced today that total December exports of $100.2 billion and imports of $156.6 billion resulted in a goods and services deficit of $56.4 billion
November's whopper (im)balance of -$60.3bn was revised down slightly to -$59.3bn, yet lest anyone take even a shred of hope from this report, note that December's deficit was higher than October's, the three largest monthly deficits have occurred in the last three months, and the seven largest deficits have occurred in the last seven months. As recently as November 2003 the US still had a monthly trade deficit under $40bn. Now $40bn is but a happy memory. No wonder the trade balance for the year just ended racks up to -$617.7bn, 24% larger than 2003 and a stunning 46% larger than 2002.

The gaping maw of the US consumer continues to widen. In December, non-petroleum goods imports rose to $113.8bn, the highest level ever. On the year, total non-petroleum imports (goods and services) were 14.5% higher while total exports (goods and services) were 12.3% higher. Thus you don't even need the massive increase in both world oil prices and US petroleum import volumes to generate a widening deficit -- although that 35.7% jump does do it's own bit of damage.

The services surplus for December grew ever so slightly from November, but is still far below what it was in March-April 2004 and light years behind the monthly tallies of 2002. Thus in 2004 overall the US services surplus was 21% smaller than in 2002. At the same time, the goods deficit is 38% larger.

The Great and Powerful Alan tells us 2005 is finally the year this will all turn around. And Professor Marvel saw in his crystal ball that Aunt Em's real name was "Emily." The ability of each to look into the Beyond and discern the truth is downright eerie.

Well, what must the neighbors be thinking of the US now?
US Treasury bond prices fell and yields rose on Thursday as investors booked profits ahead of an auction of $14bn in 10-year paper and sold more following unexpectedly weak demand for the new notes.

The auction attracted bids worth 2.05 times the paper on offer, lower than the 2.31 average of the last 10 sales. Indirect bidders, which include foreign central banks, took 28.5 per cent of the offering, below the 31.5 per cent average of recent auctions and well below the 45 per cent taken during sales of three- and five-year paper earlier in the week.

�This auction has to be seen as disappointing,� said Brian Robinson at 4Cast economic consultancy, who noted two of the the three notes sold this week were now trading below their issue price.
As Gary Pollack of Deutsche Bank Private Wealth Management says over at Bloomberg, "There's very little incentive to keep buying Treasuries", and thus when the central banks of the world lose their appetite, the major buyer of these clunkers disappears, too.

Of course, this is hardly reason to fear that East Asia is about to jump the dollar ship. Central banks turned out well for the five-year bond auction earlier in the week, and with the broad dollar at its highest since mid-November, there is little reason for the PBOC, BOJ and the rest to belly up to this bar.

Still, key your eye on these auctions. And the number of bank robberies (so says JackNYC). Two good leading indicators of the real state of the economy.

UPDATE: Briefing.com has a nice chart showing indirect bidder participation in 10-year treasury bill auctions since August 2003. A clear upward trend peaking in mid-2004, then a very erratic but secular and rather steep decline since that time.

Thursday, February 10, 2005

Brad Setser and Nouriel Roubini have a new paper out: "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of Hard Landing in 2005-2006".

Good stuff here. I look forward to reading it.

How long until the "hand-off" from wealth-effect consumption to income-based consumption? How long?

One has to give Pope Alan the props he is due for insulating the US economy from the 1997-98 East Asian financial crisis as well as setting the US up as the consuming salvation of global capitalism in that period of crisis. By loosening US monetary policy 75 basis points in six weeks, Alan supported the equity bubble and laid the foundation for wealth-effect consumption throughout the late 1990s. The idea, of course, was that wealth-effect consumption would be strictly temporary. Once we were over this rough patch, things would get back to "normal". Americans would consume in line with their income, East Asia would get back on its feet as a source of global demand as well as global supply, and we would all roll merrily along.

Of course, things didn't work out that way. The popping of the asset bubble in 2000 simply ushered in another round of monetary loosening from Pope Alan and his College of Governors, and as day follows night, another wealth-effect round of consumption began, this time founded upon housing rather than equities. But again, this was all supposed to be temporary. Once we were over this rough patch, things would get back to "normal". Americans would consume in line with their income, the world economy would become a source of robust demand as well as supply, and we would all roll merrily along.

Of course, things didn't work out that way. Again. By 2004 Greenspan was eagerly urging the property bubble along by pushing homeowners who had refinanced 30-year FRMs at 5.2% to jump into short-term ARMs at under 4.0%. But surely the US job market would resurrect, even though mired in the longest "jobless recovery" since the Great Depression.

Alas, it never did. At the end of January 2005 the US economy was still 760,000 private sector jobs short of where it was in January 2001, officially giving George W. the honor of being the first President since Herbert Hoover to end his term with fewer jobs than he began it with. More than that, real hourly wages in the US actually fell in 2004, the first time that has happened since 1993. This is an unprecedented (for the New Deal and after era) disconnect between GDP growth on the one hand and job and wage growth on the other.

Yet the Beatified Banker continues to tell us that robust income-based consumption is just around the corner -- that the "hand-off" from inflated assets to growing wages and salaries will soon be upon us. In Stephen Roach's words,
Greenspan also expresses the belief that �An increase in household saving should also act to diminish borrowing from abroad.� This is a key assertion. What he is saying implicitly is that the Fed will need to withdraw support from the Asset Economy by restoring some semblance of normalcy to America�s real interest rate structure. What he is also implying is the hope that the US labor market will now provide increased support to the American consumer -- in essence, spurring the long-awaited �hand-off� from the new asset economy back to the more traditional income economy. January�s disappointing employment survey -- just the latest in a long string of subpar gains on the hiring front -- underscores how difficult it will be to execute this hand-off.
Some see the demise of rapid US productivity growth as the harbinger of new Happy Days of Labor, the latest made up reason to come down the pike explaining why labor's doldrums just have to end sooner or later.

For something closer to reality, check out what Wal-Mart has done in Quebec.
The Canadian arm of U.S. retailing giant Wal-Mart Stores Inc. said its store in Jonquiere, Quebec, will close this spring after becoming the first unionized Wal-Mart in North America about six months ago.
McDonald's did the same thing when one of their Quebec stores unionized. But the home office in Little Rock assures us this has nothing to do with union-busting.

The contradictions of capitalism which were ably managed for thirty years after WWII, and even managed somewhat capably during the 1980s and 1990s, are catching up to us.

What does the future hold for US interest rates?

An important question, indeed, for ultra-low US interest rates are the bubble fuel behind comparatively robust US economic growth these last two years. They are sustaining the US federal government's borrowing binge as well as the US housing market, which in turn have been sustaining the US consumer, which in turn has been sustaining the export-dependent economies of East Asia and Europe as well as generating an unsustainable current account deficit for 2004:IV well in excess of 6% of GDP.

The conventional wisdom for over a year has been that the Fed will keep raising the federal funds rate to the point of "neutrality," whatever that is. With US growth around 4% in 2004, one would think that neutrality was somewhere in that vicinity. Into the fray wades Atlanta Fed President Jack Guynn, himself quite practiced in the art of Fedspeak.
The Federal Reserve still has "got a ways to go" on raising interest rates but may need to change the language in its policy statement, Federal Reserve Bank of Atlanta President Jack Guynn is quoted as saying in an article in the Wall Street Journal online Wednesday.

Guynn also is quoted as saying the Fed may have to change the language of its statement "not too far down the road," and says the language change could include dropping the words "measured" and "accommodative."

The language change may come sooner or later, "and maybe sooner," Guynn is quoted as saying.

"You can imagine not too far down the road where some things in the statement aren't going to be appropriate," Guynn is quoted as saying. "And we need to decide how and when to change some of that wording." "If we stay on the path we're on and withdraw some of the accommodation we've had in place ... we'll be at a point it's not quite as clear how much more we need to do and how quickly we need to do it," said Guynn
Markets took this as a signal that the Fed was nearly finished with rate hikes.
"This is a dovish comment for Guynn," said James Glassman, senior economist at J.P. Morgan, noting Guynn had a reputation as an inflation hawk.
and
``For many months, many have thought that removal of the word `measured' would be a signal of more aggressive rate hikes,'' said Paul McCulley, a managing director at Newport Beach, California-based Pacific Investment Management Co., which runs the world's largest bond fund. ``The market is finally recognizing just the opposite.''
Yet when I first read this statement, I had exactly the opposite reaction. So, too, did the markets, at least initially. According to Bloomberg,
The dollar initially gained on Guynn's comments as some traders interpreted them to mean the Fed will opt for larger rate boosts going forward, expanding the U.S. rate advantage relative to Europe, said T.J. Marta, a currency strategist in New York at RBC Capital Markets, a unit of Canada's biggest bank.
I have to agree with Marta. If the Fed has "got a ways to go" and is considering dropping the words "measured" and "accomodative", if the Fed may "withdraw some of the accommodation", then how can one jump to the conclusion that the Fed is going to top off at 3.00%? Greenspan himself is even owning up to his role in blowing bubbles with low interest rates. It sounds like the Fed is trying to signal the market that 50 basis point hikes are more likely in the future, and that 3% is nowhere near the ceiling.

And yet what did the markets do? They pulled the 10-year down under 4% for the first time since March 2004 (excepting a one-day dip to 3.99% in October). The 30-year FRM is down to 5.63% as well.

Without markedly higher real US interest rates, it is impossible for the US current account deficit to be brought under control. While Greenspan thinks the weakening dollar will now finally begin balancing US-Europe trade, there is no reason in the world to believe that US-Asian trade will begin balancing. And with oil staying above $40 for the foreseeable future, the US will continue to import and import and import. It wasn't that long ago, after all, that a $50bn monthly trade deficit was considered monstrous. Now it would be a welcomed as a kitten.

Wednesday, February 09, 2005

When I said that I hoped to be back to blogging on Wednesday, I bet you thought I meant last Wednesday, didn't you? Yeah, so did I. To make a long story short, it's been a bit more troublesome than I had expected setting up internet service here at the house in the London area. I've even been reduced to using AOL!

But now that I have a weekend of Six Nations rugby matches under my belt, a Newkie Brown down the hatch, and a load of blogging to catch up on, it's full steam ahead!

I hope my neglect of you all these last ten days hasn't driven you irreversably into the arms of Brad Setser . . .