Canada is to the United States?
Large in area, scarcely populated, cold and a major supplier of natural resources to its large southern neighbor …
Well, not yet.
Russia, I think, generally exports its energy to Europe, not to China. The pipelines flow west, not south and east.
But that may be changing.
It seems like the Yukos stake formerly held by western investors is being offered to China. Before, Khodorkovsky controlled Yukos and foreign — mostly western — investors had a minority stake; now, the Russian state seems likely to gain majority control, with China getting a minority stake.
From Reuters: “Make no bones about it, mortgages really went global in 2004,” said Arthur Frank, director of MBS research at Nomura Securities International. “Overseas investors had dollars to put to work and MBS were their vehicle of choice, offering them an attractive pick-up in yield over Treasuries …. “Foreign demand has certainly climbed over the years, but it picked up rapidly this year,” said Frank.
Europeans invest in emerging Asia. That capital inflow would naturally tend to drive up emerging Asian currencies v. the euro. But emerging Asian currencies are generally stable v. the euro. In many cases, emerging Asian currencies are actually falling v. the euro. China, for example, is tracking the dollar down. To avoid appreciating v. the euro — or v. the dollar — Emerging Asian central banks intervene in the foreign currency market. Rather than financing a current account deficit in emerging Asia, the capital inflow from Europe finances reserve accumulation in emerging Asia. Most of those reserves are invested in US dollars.
General Sinseki famously — and it seems accurately — warned of the risks of a “12 division strategy and a 10 division army.” To paraphase the US Defense Secretary: You fight a war with the army you have, not the army you want. But if you don’t plan realistically for your future commitments, your means are likely to lag your commitments. The US would be in better shape right now if it had started training and equipping a couple new army divisions back in early 2002.
The same is true of the federal budget. Ends (spending) have to match means (tax revenue) over time — though the federal government’s ability to borrow means that “over time” can be “over a very long time.” Right now we have a 10 division revenue base — federal taxation as a percent of GDP is at its lowest level since the 1950s: 16.2% of GDP in 2004. Alas we have a 12 division spending strategy: spending was just a bit under 20% of GDP in 2004, for a deficit of between 3.6 and 3.7% of GDP.
The IMF’s typical diagnosis of an emerging economies problem is “its mostly fiscal”, or so the wonky saying goes. Larry Rohter of the New York Times makes the argument that Argentina’s post 2001 success hinges on its heterorthodox economics: I am not convinced.
The number one reason for Argentina’s financial and economic stabilization is its belated conversion to fiscal discipline — or what in the old days might have been called a conservative fiscal policy. Why no hyper-inflation after Argentina’s default? The government matched revenues and expenditures, avoiding the need to print money. Hardly radical.
If anyone thinks that what the world really needs right now is a weaker Chinese renminbi, do let me know. Yet that is exactly what the markets have delivered this week …
It seems pretty clear that Bush economic policy is not passing the global test. But the tumbling dollar (it has tracked the renminbi down … ) has yet to hit the Bush Administration where it would hurt: the price for the ten-year treasury bond needs to start to tumble as well. That just might prompt a much needed reevaluation of the Administration’s second term economic priorities.
My modest proposal: anyone writing about Social Security should have to pass a test demonstrating that they have read the Social Securities trustees report, and understand the basic dynamics of a system with a Trust Fund holding government bonds.
There is a certain “obvious” logic which suggests social security should face problems over the next few years — America is aging, the baby boom will soon retire, the number of workers per retiree will fall. That seems to suggest that social security should face troubles — that was what I thought, before, like Kevin Drum, I actually looked at the trustees report.
The funny thing is that social security can pay full benefits to baby boomers, even with conservative (in the sense of not unduely optimstic) assumptions. The coming retirement of the baby boomers is not a problem for social security; it is a problem for the rest of the government (the “general fund”). Remember, social security is running a cash surplus, taking in more in taxes than it pays in benefits, and will do so far at least ten more years (the tipping point is 2018). As more and more baby boomer retire, that cash surplus will slowly shrink and then disappear, meaning social security has less to lend to the rest of the government. The first problem the retirement of the baby boom creates come not with social security, but with the rest of the government. Then from 2018 to 2042 (or longer if you believe the CBO), social security has to draw on the accumulated assets of the trust fund. This too is a problem not for social security — it can draw on the trust funds’ assets and ongoing payroll taxes to pay all benefits — but for the general fund. Right now, interest paid to the social security trust fund is reinvested back in treasuries — i.e. lent back to the government. Compound interest leads the assets in the trust fund to build up over time. But they have to drawn down to fund the baby boom’s retirement — the social security will start using interest payments not to lend back to the government, but to pay benefits, and then it will start to redeem its stock of bonds to pay benefits (not a problem if the general fund is solvent — it can just sell bonds to private actors to pay off the trust fund). Again, the problems created by the baby boom show up first in the general fund, not in social security.
My harping on the fact that US economic policy now has to pass a global test is not simply meant to score rhetorical points. I suspect that the same folks who financed the expansion of the US current account deficit will end up having to finance a substantial chunk of the ongoing deficits that are associated with a gradual adjustment path.
As one market wag put it:
“Bush’s strong-dollar policy is, in practical terms, to maintain a pool of fools to buy it all the way down,” a fund manager was quoted by Bloomberg news agency as saying.”
The most likely “fools” are the same set of fools who are financing the United States now: the world’s central banks.
A 5% of GDP current account deficit is an improvement over what we have now, but it is still a big number, and implies lots of external borrowing. The US cannot suddenly go from say $450 billion plus in reserve financing (the actual number in 2003 was $440 billion, this year’s number could well be larger) to a more normal number of $100 billion without experiencing a lot of pain. Our friends in the private markets are not likely to extend new financing to the US as central banks withdraw their financing. They would rather wait until after the dollar has finished falling, and then snap up US assets on the cheap.
I am going to be away from my desk next week, and don’t expect to be posting much — at least not until next Friday.
I’ll miss three key data releases:
The October trade data on Tuesday.
The October Treasury data on foreign purchases of long-term securities on Wednesday.
And the third quarter capital and current account data on Thursday.
I suspect that these releases will get a lot more than usual scrutiny in the financial markets, and in the market place of ideals. General Glut usually dissects the monthly trade data, for example.
Here is my quick advance take on what to look for the trade and balance of payments data releases — I have no clue what to expect in the Treasury capital inflows data.The trade data. I have a suspicion that the October monthly trade deficit will be a bit larger than the $51.6 billion September deficit. Why — Oil. We already know that oil import prices ticked up in October (they fell in November). And the September oil import volumes were quite low. Exhibit 17 (p. 25) of last month’s trade release tells you what you need to know — a fall in import volumes from 430 thousand barrels to around 390 thousand barrels knocked $1 billion off the September trade deficit.
That’s the tag on p. C4 of the Wall Street Journal.
The smart money — and regular readers of this blog — know that this is real question is not whether central banks are, in aggregate, dumping dollars, but whether central banks are willing to keep on buying dollars and then to invest those dollars in dollar denominated securities.
Even with the change in the dollar/ euro, I suspect the US will have a substantial, $650 billion plus current account deficit next year — assuming US growth remains strong, the US fiscal deficit does not fall below $350 billion and oil is in the high 30s or low 40s.
Financing that deficit at current exchange rates (vis a vis Asia) and current interest rates required $440 billion of net central bank purchases of dollar assets in 2003, a comparable amount in 2004 (we don’t have the final data, but some indicators suggest that if anything the pace of central bank financing has if anything picked up slightly), and no doubt a similar amount of new central bank financing in 2005 and 2006 — unless something radical changes.