Transcript שקופית 1

Globalization, Financial Stability and
Depression
Assaf Razin, Tel-Aviv University
Fall 2008
Updated 2010
1
Chronology of Crisis
Sept 15 2008— •
Lehman Brothers
went belly up.
Sept 16, 2008: •
A.I.G. is effectively
nationalized
Sept 18, 2008— •
Bank of America
bought Merril
Lynch. •
December 2008— •
the Federal
Reserve cuts
interest rates
virtually to zero
Understanding what’s going on:
Like shooting at a moving target
Housing bubble. •
Subprime •
mortgage crisis
Financial sector’s •
toxic assets
Liquidity crisis •
Zero interest rate. •
Unconventional •
central banking
Liquidity trap? •
Global Crisis
Interest Rate Policies
Fed Rate
Emerging stars buffeted by
global storm
Depression Economics
Credit Market : September 2008

financial institutions hold significant assets that are
backed by mortgage payments. Two years ago, many of
those mortgage-backed securities (MBS) were rated
AAA, very likely to yield a steady stream of payments
with minimal risk of default. This made the assets liquid.
If a financial institution needed cash, it could quickly sell
these securities at a fair market price, the present value
of the stream of payments. A buyer did not have to
worry about the exact composition of the assets it
purchased, because the stream of payments was safe.
Libor-OIS spreads reached 200
basis points in September 2008
when Congress failed to pass the
Paulson plan
Bank bailouts
Sources for charts: Robert Shiller,
Andrew Smithers; Thomson
Datastream
Mortgage and Housing Prices

Because the amount owed on the
mortgage loan does not depend on the
value of the house, a decline in the house
value below the amount of the mortgage
has two effects.
Family Costs and Lender Costs

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1. family with no remaining home equity may
walk away from the house. The family suffers
the loss of equity and the cost of moving to
another house.
2. The lender suffers a decline in the value of
the mortgage as house prices fall. The lender
fixes the house and sells it. Foreclosure process
take 6 to 9 months. The lender pays for the fix
up and receives low price from distress sale.
Mortgage Finance

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The common form of mortgage commits the household
to make equal monthly payments for 30 years. These
mortgages payy off with 10 years because households
sell the property or does refinance.
New model: The borrower applies to a mortgage broker,
receives money from a wholesale lender, and make
payments to a servicer. The servicer passes on each
payment to a master servicer, who pays it out to holders
of a mortgage-based-security (MBS), who pass it on to
the adminstrator of a collateralized debt obligation
(CDO), who passes it on to investors in CDOs.
Mortgage-backed Securities
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How to value MBSs?
Imagine you bought a $100,000 house a year
ago, with a $10,000 down payment.
If the value of the house rises, you are “in the
money”.
If it falls, you can walk away. You loose the
original $10,000 investment, but are safe in the
knowledge that the lender cannot seize your
other assets. .
Mortgage as option, not loan

This mortgage is therefore not a loan but
an option: it allowed for gains if house
prices rose, but cost relatively little if
prices fell.
Akerlof’s Problem

When house prices started to decline, this
has had bigger effect on some MBS than
other MBSs, depending on the complexity
of the mortgages that backed the
securities. Owners of MBS have strong
incentive to price each an every one of
them. They have superior information
over the market buyers. As in Akerlof’s
Lemmons Problem, the market for MBS
will collapse.
Market illiquidity

The buyer hopes that the seller sells the
security because he needs cash. But the
buyer worries that the seller will unloads
the most troubled securities. This makes
the market illiquid.
Fire sale

To buy MBS in such illiquid market you
first need the asessment of the value of
MBSs by an independent authority. The
overpricing is built in because the worst
quality MBSs will be unloaded by the
bank. Their price is below the average
hold-to-maturity value of MBS.
Hold-to-maturity price
The True value of the average MBS may in
fact be much higher. This is the hold to
maturity price, adjusted to some average
default probability.
Bidder’s auction valuation in the
First Version of the Paulson’s Plan

Bidder’s auction valuation is not the “no
bail-out” valuation. It is the opportunity
cost for not selling the asset in the
auction. This opportunity cost is the price
the bidder can sell the asset on the open
market immediately after the auction;
when some big X percent of the asset are
already removed from the market by the
treasury.
$700bn of sub-prime and market
valuations

Imagine artificially pulling $700bn of
subprime off the market. This must
dramatically increase market prices and
auction valuations. This, in principle (not
in actual magnitude; because the Paulson
plan will work in stages) is a proxy for
post-bail-out valuations.
Sub-prime default rates

Subprime default rates are highly
correlated with real estate, the troubled
asset class underpinning the value of
MBSs.
Credit freeze as a Lemons’
problem for Financial institutions

Financial service institutions whose market
values are based on their real estate
investments, and MBS investments, suffer
also from the Lemons’ problem. This is
why they refuse to lend to each other.
The inter bank credit market, and the
money market comes to a halt.
Raising new capital
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Banks fear that any bank that wants to
borrow is on the verge
Of bankruptcy and they refuse to lend.
A “Theoretical” solution to Toxic
Assets
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The government could force owners to sell
all their MBS portfolio, rather than the
MBS that the financial institution would
like to unload, at an average hold-tomaturity price .
Japan’s 1990s

Japan’s experience in the 1990s is
cautionary example of the peril of
propping up banks after a real estate
boom ends. The Japanese government
helped keep many troubled banks afloat,
hoping to avoid the pain of bank failures,
only to extend the economic downturn as
consumer spending and job growth fell.
Japan’s Banks

THE 1990 COLLAPSE OF AN ASSET
BUBBLE PROVOKED A SHARP FALL IN
THE VALUE OF PROPERTY AND
EQUITY THAT UNDERPINNED BANKS’
BALANCE SHEETS. BUT BANKS
IGNORED THEIR PROBLEMS UNTIL
1997 WHEN SANYO SECURITIES,
YAMAICHI SECURITIES AND
HOKKAIDO TAKUSHOKU BANK ALL
FAILED.
Reluctance to recapitalize by state
funds
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A RELUCTANCE TO ADMIT THE SCALE OF THE
PROBLEM MEANT CAPITAL INJECTIONS TOOK
PLACE IN THREE MAIN TRANCHES. THE FIRST
CAME IN THE SPRING OF 1998, WHEN THE
GOVERNMENT INJECTED Y1,800BN ($18BN,
£11BN, €14BN) INTO 21 INSTITUTIONS. THE
MONEY, WHICH CAME IN THE FORM OF
PREFERENCE SHARES, HAD FEW STRINGS
ATTACHED. THE SECOND FOLLOWED THE
COLLAPSE IN 1998 OF NIPPON CREDIT BANK
AND LONG TERM CREDIT BANK. A TIGHTENING
OF RULES FORCED 32 INSTITUTIONS TO RAISE
CAPITAL AND IN 1999 TO ACCEPT GOVERNMENT
FUNDS TOTALLING Y8,600BN.
Conditions set by government

Conditions grew stricter. “The first time,
the government injections were very
generous, depending on the banks’ own
will. The second time was more forcible,”
says the former BoJ official. “The first
priority was that in a certain period they
had to return from red to black, second
was to lend to SMEs [small and mediumsized enterprises] and third was a host of
conditions, such as cutting their payroll,”
Non performing loans

By March 2005, non-performing loans
were at 2.9 per cent of banks’ total assets
from 8.4 per cent at the height of the
crisis.
Sweden in the 1990s

Sweden in the early 1990s took a middle
pathswiftly taking over many of its troubled
banks. The American bailout plan, economists
say, takes a page from the Swedish example by
making the government a shareholder in banks
participating in the program. But, they add, the
American banking system is so much larger and
diverse than Sweden’s that the parallels are
limited.
Capital injection and tax payers

In exchange for the capital injection by
the government, taxpayers might be
protected through preferred shares (or
warrants), giving them dividends in the
future.
Fed buying unsecured loans

The problem in the interbank market is
the lack of availability of longer than over
night loans. Banks can get some short
term funding, but only on a collateralized
basis. Unsecured borrowing rates for , say
three-month Libor rates, are sky high
during liquidity crunch.
unsecured loans from the private
market
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There are two reasons for why banks cannot
obtain short-term unsecured loans from the
private market.
(1) the classic coordination problem: “I will not
lend you money for a month if I think that
everyone else will only lend you money for a
day, allowing them to pull out tomorrow and
leave me stranded.”- a liquidity risk.
(2)Credit risk of lending to banks.
Fed’s new scheme?
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Fed is considering:
(1) Unsecured term loans by the Fed at a
premium over the federal funds rate, that
would provide a perfect substitute to the
Libor.
(2)using unsecured lending to shore up
the collapsing commercial paper market in
which corporations raise funds.
Recapitalization of banks
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A scheme, similar to the operation done
by the Swedish government in the early
1990s, is government buying of All banks’
troubled assets.
Paulson’s Original Plan (TARPTroubled Asset Relief Program)

In the current crisis, you do want to get
rid of the bad assets from the banks, to
get markets working again. But the key is
going to be in the details of how the
bailout works. You don’t want it to be a
subsidy in disguise that keeps insolvent
banks alive. That would just prolong the
economic pain.
Pricing of mortgage based
securities in trouble

the overriding question of how to price
mortgage backed securities remains
unanswered. The authorities appear to want
something between fire-sale prices and the
value of securities if held to maturity. Figuring
out the latter is tricky without detailed
information from the banks – and certainty on
where house prices will eventually settle.
Insisting on the former, however, would defeat
the objective of ungumming the market while
also adding more strain to banks’ balance
sheets.
Differences between bailout and
government spending

First, note that there is a major difference
between a program to support the
financial sector and $700bn in new
outlays. No one is contemplating that the
$700b in the Paulson plan will be given
away. All of its proposed uses involve
either purchasing assets, buying equity in
financial institutions or making loans that
earn interest.
2nd difference

Second, the usual concern about GOVERNMENT
BUDGET DEFICITS IS THAT THE NEED FOR
GOVERNMENT BONDS TO BE HELD BY INVESTORS
WILL CROWD OUT OTHER, MORE PRODUCTIVE,
INVESTMENTS OR FORCE GREATER DEPENDENCE
ON FOREIGN SUPPLIERS OF CAPITAL. TO THE
EXTENT THAT THE GOVERNMENT PURCHASES
ASSETS SUCH AS MORTGAGE-BACKED
SECURITIES WITH INCREASED ISSUANCE OF
GOVERNMENT DEBT, THERE IS NO SUCH EFFECT.
Mark to market and illiquidity

Market-to-market accounting generates further
illiquidity during credit crunches.
Keynes’ Metaphor for a Bubble

44
Consider beauty competitions famously
described by John Maynard Keynes, in
which the winner was the contestant who
chose the six faces most popular with all
contestants. The result, Keynes observed,
was that the task was not to choose the
most beautiful face, but the face that
average opinion would think that average
opinion would find the most beautiful. In
this way beliefs feed on themselves and
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45
Written in 1859, in a history of
the commercial crisis of 185758.
Each separate panic has had its own
distinctive features, but all have
resembled each other in occurring
immediately after a period of apparent
prosperity, the hollowness of which it has
exposed. So uniform is this sequence, that
whenever we find ourselves under
circumstances that enable the acquisition
of rapid fortunes, otherwise than by the
road of plodding industry, we may almost
History
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46
Carmen Reinhart of Maryland and Ken
Rogoff of Harvard, have recently published
an analysis of the current financial crisis in
the context of what they identify as the
previous 18 banking crises in industrial
countries since the second world war.
They find what they call "stunning
qualitative and quantitative parallels
across a number of standard financial
crisis indicators" - the common themes
THE LENDER OF LAST
RESORT
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47
The role of lender of last resort was
classically defined by Walter Bagehot. His
great book Lombard Street was published
in 1873, and set out what has become the
guiding mantra for central banks in times
of crisis ever since: lend freely at high
rates against good collateral. Lend freely,
in his words, "to stay the panic". At high
rates, so that "no one may borrow out of
idle precaution without paying well for it".
Fannie Mae and Freddie Mac
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The GSEs backed more than 80 percent of recent US
mortgages.
The US treasury , as of September 2008, owns
80 percent of the stocks. In addition to taking controls of
the companies, the treasury also invests in mortgagebacked securities to support for home buyers.
Debts of the institutions were held by foreign investors
and foreign central banks.
A meltdown would have threatened the credibility of US
government.
Asia
49
Emerging Markets
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Emerging markets’ fiscal and monetary
policy cannot “print” hard currency, and
their attempt to refloat their economies
may end up with high inflation or balanceof-payments crisis. This has led the Fed,
and the IMF to offer liquidity credit lines
and structural adjustment programs.
These measures may help offset effects of
“sudden stops”, like the one in 1998.
51
Index of Financial Instability
52
An Historical Perspective
53
Sovereign Debt Default Through
Inflation
54
Currency Crises and Inflation
Crises Travel Hand in Hand
55
Housing, the Sub-prime
Mortgage Market, and the
Financial Turmoil
The U.S. economy experienced a mild recession in 2001. During the ensuing
recovery, above-trend growth was accompanied by rising rates of resource
utilization, particularly after the expansion picked up steam in mid-2003.
Unemployment rate declined from a high of 6.3 percent in June 2003 to 4.4
percent in March 2007
56
US is not the only country
which had a housing bubble:
the portion of the house
price rises explained by
fundamentals was larger
in, UK, Australia, France
and Spain
Rogoff: ft sept 18 2007
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ONE OF THE MOST EXTRAORDINARY FEATURES
OF THE PAST MONTH IS THE EXTENT TO WHICH
THE DOLLAR HAS REMAINED IMMUNE TO A
ONCE-IN-A-LIFETIME FINANCIAL CRISIS. IF THE
US WERE AN EMERGING MARKET COUNTRY, ITS
EXCHANGE RATE WOULD BE PLUMMETING AND
INTEREST RATES ON GOVERNMENT DEBT WOULD
BE SOARING. INSTEAD, THE DOLLAR HAS
ACTUALLY STRENGTHENED MODESTLY, WHILE
INTEREST RATES ON THREE- MONTH US
TREASURY BILLS HAVE NOW REACHED 54-YEAR
LOWS. IT IS ALMOST AS IF THE MORE THE US
MESSES UP, THE MORE THE WORLD LOVES IT.
Investment Banks

By forcing the fourth largest investment bank,
Lehman Brothers, into bankruptcy and
Merrill Lynch into a distressed sale to Bank of
America, they helped to facilitate a badly
needed consolidation in the financial services
sector. However, at this juncture, there is every
possibility that the credit crisis will radiate out
into corporate, consumer and municipal debt.
Regardless of the Fed and Treasury’s most
determined efforts, the political pressures for a
much larger bail-out, and pressures from the
continued volatility in financial markets, are
going to be irresistible.
Bail Outs

the financial crisis has probably already added
at most $200bn-$300bn to net debt, taking
into account the likely losses on nationalising
the mortgage giants Freddie Mac and
Fannie Mae, the costs of the $29bn March
bail-out of investment bank Bear Stearns, the
potential fallout from the various junk
collateral the Federal Reserve has taken on to
its balance sheet in the last few months, and
finally, Wednesday’s $85bn bail-out of the
insurance giant AIG .
Moral Hazard

A HOUSE INSURED FOR MORE THAN
ITS VALUE IS ALWAYS CONSIDERED
A FIRE RISK. BUT HOME INSURANCE
IS REGULATED AND ARSON IS A
CRIMINAL OFFENCE THAT KEEPS
PEOPLE HONEST, MOST OF THE TIME
CDS

The same cannot be said of the credit
default swap industry. The private, overthe-counter market allowing two parties to
bet on the likelihood of a company
defaulting on its debt has grown to about
$90 trillion in notional amounts insured –
probably more than double the total
outstanding credit in the world
overshooting

The pressure to hedge has led most of the
liquid contract to overshoot in the pricing
default risks. The same prices are then
used as a supposedly objective indicators
to values of stocks that the CDS are
designed to hedge.
Regulatory arbitrage

Aig had written coverage for more than
$300bnof credit insurance for European
banks. From their annual report: “for the
purpose of providing them with regulatory
capital relief rather than risk mitigation, in
exchange for a minimum guaranteed fee.”
A formal default by AIG would have
exposed European banks to large
increases in regulatory capital
requirements, with negative effects on
their rating.
Regulation: Bad Example

The Office of Federal Housing Enterprize
Oversight was regulating the Freddie Mac
and Fannie Mae to end up in the
nationalization of these Government
Sponsored Enterprizes(GSE) Institutions.
Credit Crunch 2008
Market efficiency?
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67
The credit crisis has destroyed the idea
that unregulated financial markets always
efficiently channel savings to the most
promising investment projects.
Financial boom and bust cycle
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68
Millions of US citizens took on
unsustainable debts, pushed around by
bankers and other “debt merchants” who
made a quick buck by disregarding risks.
This financial boom and bust cycle cannot
have been an example of efficient
channelling of savings into the most
promising investment projects.
Four vicious cycles
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69
“Four vicious cycles are simultaneously
under way: falling asset prices are forcing
levered holders to sell, driving prices further
down; losses at financial institutions are
reducing their ability to finance investment,
which in turn reduces asset values, causing
further losses; the weakness of the financial
system is reducing growth, which in turn
weakens the financial system; and falling
output is hitting employment, which in turn
leads to reduced demand for output”—Larry
Peak Unemployment Lagged
Trough of Output Contraction
70
Residential Property Prices
71
Interbank Lending’s Squeeze
72
Early Warnings?
Ahead of the 2007 summer’s crisis there was
growing concern that “slicing and dicing” of
debt instruments was fuelling a credit
bubble, leading to artificially low borrowing
costs, spiralling leverage and a collapse in
lending standards. At Davos for the annual
economic forum in January 2007, JeanClaude Trichet, governor of the ECB,
complained about the opacity of some
financial innovation and warned that there
73
US Economy in 2007-8
The economy continued to perform well into
2007, with solid growth through the third quarter
and unemployment remaining near recent lows.
Indicators of the underlying inflation trend, such
as core
inflation, showed signs of moderating.
74
US Housing Market
A sharp and protracted correction in the U.S. housing
market followed a multiyear boom in housing
construction and house prices. Indicating the depth of
the decline in housing, according to the most recent
available data, housing starts and new home sales
have both fallen by about 50 percent from their
respective peaks.
75
Global Saving Glut
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76
Behind this Global Saving Glut lie three
phenomena
1.–excess of retained profits (corporate
saving) over investment, of the corporate
sectors of the advanced countries,
2. --the persistent savings surpluses of a
number of mature economies, particularly
Japan and post-unification Germany.
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77
3. The switch of emerging markets into
current account surpluses.
The single best indicator of that glut has
been the low real rate of interest
at a time of fast global economic growth.
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78
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A. - the shift of crisis-hit
emerging countries from deficit into surplus,
particularly after the Asian financial
crisis,
B. - the rise of China as the world’s largest
capital exporter, despite also being the
world’s biggest investor and, more recently,
C.- the surpluses of the oil exporting
countries.
Capital Flows Destabilizing
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79
Kenneth Rogoff has argued, that the
current financial crisis is just another
emerging market
crisis, but this time the emerging market
was found inside the US. It also is another
reminder of why large net capital flows
have proved so destabilising: they only
work
if the borrowers are making investments
able to service the loans.
Although sub-prime borrowers and the investors
who hold these mortgages are the parties most
directly affected by the collapse of this market, the
consequences have been felt much more broadly.
80
On the way up, expansive sub-prime lending
increased the effective demand for housing,
pushing up prices and stimulating
construction activity.
81
On the way down, the
withdrawal of this source of
demand for housing has
exacerbated the downturn,
adding to the sharp decline in
new homebuilding and
putting downward pressure
on house prices. The addition
of foreclosed properties to
the inventories of unsold
homes is further weakening
the market.
82
The Action of the Fed
83
To help address the significant strains in shortterm money markets, the Federal Reserve has
taken a range of steps. Notably, on August 17,
the Federal Reserve Board cut the discount rate-the rate at which it lends directly to banks--by 50
basis points, or 1/2 percentage point, and it has
since maintained the spread between the federal
funds rate and the discount rate at 50 basis
points, rather than the customary 100 basis
points.2 The Fed also adjusted its usual practices
to facilitate the provision of discount window
Two Global Shocks
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84
In essence, the global economy has
received two shocks in the past 12
months—the credit crunch and higher
commodity prices.
US Growth
85
Euro-zone Growth
86
Monetary tightening?
After the Fed's rapid, pre-emptive
loosening to a federal funds rate of 2%, is
it going to not likely in the immediate
run.?tighten
If the ECB tightens and the Fed does not,
the
Will weaken against the Euro. Dollar
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87
Inflationary Pressures
88
The euro zone has a stronger
economy but much tighter
monetary conditions
Falling odds of a financial-market
catastrophe and inflation
uncomfortably high (and set to rise
higher) the balance of shocks is
shifting
(the ECB has kept short-term rates
unchanged at 4% throughout the
credit crisis)
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89
Oil Price
The developed economies consume a
disproportionate share of the world's energy,
with North America and Europe accounting for
about half of the total oil use in 2006. However,
it is the newly industrialized countries and oil
producers that account for the recent rapid
growth in demand, with Asia and the Middle
East accounting for 60% of the increase in
petroleum use between 2003 and 2006. North
America and Europe contributed only 1/5 of the
growth. In June 2008 the oil price reached $ 138
per barrel
90
Early Episode of an Oil
Price Surge
Oil price surged after Iraq’s
invasion to Kuwait, this has
largely reversed a year later after
the Iraq’s defeat in the first Gulf
war
91
China’s Oil
Consumption
Particularly dramatic in this growth in oil
consumption has been China, whose petroleum
consumption between 1990 and 2006 increased
at a 7.2% annual compound rate. It's always
amusing to project these impressive exponential
growth rates. If that rate of growth were to
continue, China would be using 20 million
barrels a day by 2020, about as much as the U.S.
is today. By 2030, China would be up to 40
mb/d, twice the current U.S. consumption.
92
China’s Growth Rates
For the past twenty years China has
achieved a growth rate averaging nearly
10 percent a ear. China’s today ranks the
fourth largest
economy in the world in terms of GDP.
Factors contributing to growth are: 1.
increasing openness in trade
2.High rate of capital investment.
3. A strengthening of the educational
system
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93
Official reserves and Inflation

94
Official reserves grew by a massive
$280bn (£140bn, €177bn) in the first half
of 2008. The central bank has
strengthened controls on capital inflows.
Consumer price inflation has risen to 8 per
cent. The currency has become more
flexible and appreciated about 20 per cent
against the dollar. But on a real tradeweighted basis the appreciation has been
only 15 per cent.
Current account, capital account
and Reserves’ account
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95
In the 1995-2000 period most of the
“action” was in the capital and reserves’
accounts:
Due to underdeveloped domestic financial
institutions , China domestic saving capital
– in a kind of “round-tripping”
Outward and inward capital
flows

96
Invested in US treasury bills, and US and
JAPAN direct investors round-tripped the
capital back into China.
Round-tripping of capital and
low domestic wages
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97
Reserve accumulation hel the Renminbi
undervalued, and helped maintained the
low the cost of inward FDI.
current account surplus
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98
Recently, China’s current account surplus
has soared, from 3.6 per cent of gross
domestic product in 2004 to 11.3 per cent
in 2007.
Asian Countries’ Exchange
Rate Regimes and Monetary
Policies
99
Appreciation of Asian
Currencies in the first Half of
2008
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100
Taiwanese Dollar—6%
Chinese Renminbi—6%
Singapore Dollar—5%
Hong Kong Dollar—0%
Thai Baht --- -11%
China’s exports are growing
more slowly than America’s
Excluding oil, the trade deficit
has fallen by almost onequarter since 2006.
101
Food and Energy
Prices:Inflation
 South Korean authorities on the last week of
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102
June 2008 sold as much as $1bn to shore up
the won, according to currency traders in
Seoul, underlining concerns in several Asian
countries about weakening currencies in the
face of oil-fuelled inflation.
Asian countries have the ammunition for such
a fight after amassing record foreign
exchange reserves since the 1997 Asian
financial -crisis. While China is the world's
runaway leader, India and South Korea have,
respectively, about $300bn and $260bn in
reserves.
Three historical precedents
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103
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The Japanese Deflation(Mid -90s)
The US recessions of 1990-91 and 200002
Three exogenous shocks played a role in
each: 1)an oil price surge (disrupting
production and taxing consumption)
2) An asset price correction, in real estate
and equities (reducing consumption
through a “wealth effect”)
Impairmaint of financial institutions’
Assets’ Price
Correction: Japan in the
1990s vs. the US
Asset price correction in Japan
has been several order of
magnitude larger than the current
shock in the US
104
US SAVING AND LOANS
CRISIS:
The saving and Loan Crisis of the
Late 1980s—the macro economic
effects are hinged on the extent to
which financial institutions need to
reduce balance sheets and
recapitalize their assets.
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The Dollar Decline
Optimists see the dollar's fall as part of
a necessary rebalancing of the world
economy. Without a change in
exchange rates, the US current
account deficit is on an explosive path.
It could widen from its current 5-6 per
cent of US gross domestic product to 8
per cent in 2008 and 12 per cent in
2010.
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The Dollar Strengthening
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Flight to safety into US treasury bills–
backed by US taxpayers.
Dollar as a Reserve Currency
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The US Federal reserve is spraying money
around the world during the Fall 2008
financial crisis. I opens credit lines of $30
billion each to Brazil, Mexico and
Singapore.
The Fed’s move underlines the status of
the dollar as the world’s reserve currency.
The US Fed becomes, in effect, the banker
of the world’s central banks.
The Adjustment to the
Dollar
Fall
As the dollar falls, there is an
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upward pressure on US import
prices and more inflationary
pressure generally. In response,
the Federal Reserve will have to
raise interest rates faster than
currently expected. Higher
interest rates will make
borrowing more expensive and
slow investment growth.
They is a negative impact on asset
valuations, including house prices. US
households, no longer living off capital
gains, will have to start saving again.
With investment down and saving up,
the current account deficit will narrow. A
significant decline in both consumption
and investment will mean a recession in
the US.
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Can Dollar loses its status as a
Reserve Currency? At present,
foreigners’ desire to hold dollar
cash and bonds as a store of
value allows the US to finance its
debt at low cost. A loss of that
status would mean a permanent
loss of wealth for the US.
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Oil Producers’
currency pegs stick
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Gulf states’ Policymakers – barring
Kuwait, which revalued its currency last
year – have struggled to defend their
currencies’ pegs to the dollar. Rising
inflation has stoked expectations of
revaluation, encouraging speculative
inflows. These, added to huge oil
revenues for many states, have fed
domestic liquidity.
Booming Credit Growth Fuels
Demand for Goods
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As a result bank lending to the private
sector, where demand for credit is already
high thanks to negative real interest rates,
is up. Booming credit growth has fuelled
domestic demand, and thus inflation. The
vicious circle has been reinforced by rate
cuts in the US, which have forced GCC
central banks to reduce domestic rates.
US Twin Deficits
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Deficits of this magnitude are not
something that foreigners would
willingly finance, especially in so far as
they reflected chronic budget deficits
rather than high levels of private
investment.
Why the US saving rate is so
low?
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The federal government is consuming at
roughly twice the rate it did a decade ago,
as a share of national income.
Among households the group whose
consumption has increased the most
rapidly is the elderly. Since 1960 average
consumption
per oldster roughly doubled relative to
average consumption per youngster.
Big reserves holders – mostly
developing countries – need
to embrace policies aimed at
stimulating domestic demand
at the expense of exports,
thus trimming current
account surpluses over time.
They must relax controls over
currencies too, so that
market-driven pressures clear
through the exchange rate
rather than FX accumulation.
None of them will embrace
measures such as these with
any great enthusiasm. It is the
challenge of the richer
economies to make them.
US Inequality
Who is paying for the growth of
the consumption of oldsters?
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Answer, in part, is US government.
Medicare and medic aid(majority of it goes
to elderly)
Global imbalances
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The US current account deficit was a record
$666 billion in 2004;fully two-thirds of
global net foreign lending:
U.S. Current Account
Deficit (% of GDP)
5.7
6
4.9
5
4.2
4
3.9
3
2
1.5
1
0
mid-90's
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2000
2001
2003
2004
End of the carry trade as we know
it in Mid 2008?
(1)First force: the •
recent rising US
dollar – against
almost everything,
driven, in part, by
falling interest rate
differentials as the
US economic
(2) The second force has been
slowdown spreads to the turn in commodity prices.
the rest of the world.
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US net external Assets turn negative:
Short term liabilities exceed corporate stock
and direct Investment on the assets side.
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• The current account deficit has been bridged by
foreign lending of two sources:
• First, European investors: attracted to the US
higher producivity business. Despite low levels of
interest rate, the Dollar depreciation against the
Euro created expectations for a subsequent
appreciation ( remember Rudi Dornbusch’s
overshooting theory?):
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Second, Asian countries’ fixed and managed
exchange rate regimes, resulted in a massive US
Dollar purchase:
Japan’s foreign-exchange intervention policy in
currency trade, to avoid the appreciation of the
Yen, yielded accumulation of $450B between 20002004.
China’s formal rigid exchange rate (8.28
Renminbi to the Dollar) required the purchase of
$275B at the relevant period.
In 2003 alone, the combined official reserves’
purchased of China and Japan amounted to $350B,
equal to 64% of the entire U.S. current account
deficit!
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What is the Asian motivation for accumulating so
many Dollars?
First, the credit dry up in the Asian Financial crisis
of 1997-1998, induced government will to rebuild a
precautionary “war chest” of liquid international
funds.
Second, and more importantly, the purchase of
Dollars to avert local currencies appreciation, kept
their domestic prices relatively low. Thus, the
funding of the U.S. current account deficit was
motivated by the desire to subsidize these
countries’ export to the U.S.
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Narrowing the US current account deficit requires
some combination of increased savings and
lower investment.
Excess World Savings:
Nevertheless, Ben Bernanke suggests that the
world suffers from too much rather than too little
saving (clue: the long-term interest rates are
extremely low across the globe). He attributes
thisto high saving by Asian economies.Currently,
also increase OPEC countries’ saving as a result of
the rise in the price of oil.
If this “savings glut” argument is correct, then
presumably there is little need to worry about
falling thrift in the U.S.
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As the Dollar falls, normally, there is an upward
pressure on the U.S. import prices which induces
inflationary pressure.
In response, the Federal Reserve is to raise interest
rates faster than expected. Higher interest rates
makes borrowing more expensive, which slows
down investments.
The inevitable implication is that the U.S.
economy will slow; or possibly succumb to
recession?
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Due to the US huge domestic market, the US
Dollar would need to fall dramatically to reduce
world demand for US exports and to reduce US
demand for imports from the rest of the world, to
narrow down the US current account deficit
significantly.
Moreover, the Asian central banks exchange rate
policy stalls this process by acquiring sack-loads of
Dollars, slowing the decline of the US Dollar,
which enables America to borrow more.
Thus, the natural adjustment process of a
furtherdecline of the US Dollar, when it will come,
is bound to be sharper.
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Moreover, in order to keep their exchange-rate
operations from causing inflation in China, the
Chinese central bank would keep on selling
bonds on the China’s domestic market, in order to
mop up excess money supply.
However, this absorption (China central bank
buying US treasuries and simultaneously selling
domestic bonds) is expensive to China’s
authorities: In many cases the interest rates on
domestic bonds are significantly higher than on
the treasuries the central banks are buying. The
World Bank estimates that this differential cost the
emerging-market central banks $250M a year for
every $10B they hold in reserves.
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A relative pickup in Europe’s productivity growth
rates (as in thec last quarter), would lead to closing
of global imbalances only if the relative
productivity jump were in non-tradable goods
production, rather than tradable goods production.
Contrary to conventional wisdom, as the global
recovery rebalances towards growth in Europe and
Japan, the U.S. current account deficit could
actually become larger rather than smaller, at least
initially.
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of Payments’
Adjustment
TheBalance
favorable
return
differential for
the USA is associated with the ‘equity
premium’, together with the higher
weight of equities in total assets than
in total liabilities.
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Importantly, this wealth transfer may occur via a
depreciation of the Dollar.
Almost all of U.S. foreign liabilities are in Dollars
wheras 70% of U.S. foreign assets are in foreign
currencies.
Gian Maria Milesi-Ferretti, calculates that between 2002
and 2004 more than 75% of the increase in America's
net foreign indebtedness caused by the current-account
deficit was offset by changes in the value of external
assets and liabilities as a result of the dollar's fall. Thus a
big external deficit does not necessarily imply a
commensurate rise in net indebtedness to foreigners.
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With large gross asset and liability positions, a
change in the Dollar exchange rate can transfer
large amounts of wealth across countries: A back
of the envelope calculation indicates that a 10%
depreciation of the Dollar, represents, ceteris
paribus, a transfer of 5% of U.S. GDP from the rest
of the world to the U.S.
For comparison, the U.S. trade deficit on goods
and services 6 percent of GDP in 2005.
This means the through the trade channel the
annual transfer of spending from the US to the rest
of the world is similar to the transfer of wealth
through annual 10 percent depreciation of the US
dollar.
During 2002-2004 the weakening dollar and stronger
stock market performance overseas with respect to the
United States generated capital gains for the
U.S. amounting to over 10 percent of GDP.
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 Historically, 31% of the international
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adjustment of the U.S. current account
deficit is realized through valuation effects
(The financial adjustment channel) on
average.
These considerations tend to lengthen the
period of unprecedented levels of U.S.
current account deficits; but not to prevent a
large adjustment (through the The trade
adjustment channel) in the future.
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Tentative Conclusions
During the past few years the United States have relied on sizable capital gains to
stabilize its external position. looking forward, exploiting this channel again would
require.
Notwithstanding the importance of valuation effects, the current level of U.S. trade
deficits
cannot be permanently sustained and global adjustment requires the rebalancing of
savings and investment flows between the U.S. and the rest of the world.
If the trends in imports and exports of the past 15 years were to continue, US net liabilities could jump from
Roughly a quarter of gross domestic product at the end of 2003 to 120 per cent of GDP by 2014.
Even if the current account deficit were to stabilize as a share of GDP, the ratio would reach 80 per cent of GDP.
It is hard to believe that the foreign private sector would willingly hold such huge claims, denominated in the
dollar, at current US asset prices.
Is the US current account deficit sustainable in its
present magnitudes?
Economic analysis would say NO. Timing of a reversal?
A continued sizable differential in rates of return between U.S. external assets and
liabilities.
Logic would suggest that this channel cannot be exploited systematically for a
prolonged
period of time—it would likely require persistent dollar depreciation, which would
eventually be incorporated in inflation expectations and ex-ante interest rate
differentials.
Not likely!