Liquidity/Rollover Risk on US Assets? A Nightmare Hard Landing Scenario for the US $ and the US Bond Market..
One of the most typical and common features of currency and financial crises in emerging market economies is “liquidity” or “rollover” risk. If a country has a large amount of short term debt that is coming to maturity and investors are unwilling to roll over (refinance) such debt, then a liquidity or debt rollover crisis may occur. The debt coming to maturity is usually the foreign currency (or foreign currency-linked) debt of the government (as the infamous Mexican Tesobonos in 1994) or the short-term foreign currency liabilities of the banking system (as the $20 billion plus of short-term cross-border inter-bank lines in Korea in 1997). Similar liquidity or rollover crises (also referred to as roll-off crises as investors roll off rather than roll over their claims) have been observed in every emerging market economy crisis in the last decade (see Chapter two of my new book with Brad Setser).
Thus, as the US economy currently looks like the biggest and most leveraged emerging market of all, the legitimate question emerges of whether the US could be subject to such a liquidity run or rollover crisis.
At first, the answer to such a question would appear to be negative for the following reasons: rollover risk is high if the short term liabilities are in a foreign currency and the country has limited short-term foreign assets to service such liabilities in case the foreign investors are unwilling to rollover their claims. In the case of the US instead, its domestic government debt is in local currency; thus, even if the US were to be subject to a roll-off crisis (investors rolling off rather than rolling over maturing Treasuries), it would not need to use scarce forex reserves to service its foreign debt; it could just print dollars to do that (and/or sharply increase interest rates). And indeed, it is highly beneficial to be a country not subject to “original sin” and the ensuing “liability dollarization”; lucky those who can borrow in their own currency and who are also reserve currencies.
But things get a little more complicated when one scratches the surface of the issue. Even if a pure rollover crisis can be averted if the short-term claims of the government are in local currency as the country can always print local currency to finance such a run, the consequence of such monetary financing of a roll-off crisis would be a surge of liquidity that would lead to a sharp fall in the currency value. So, you can avoid a rollover crisis by printing money but you then exacerbate the currency crisis.
Avoiding a severe currency crisis then becomes unfeasible for two reasons: first, the US does not have much forex reserves and thus could not deal with a free fall of the dollar via unsterilized forex intervention. Second, in this roll-off scenario an attempt to increase domestic interest rates to stem the currency run would not work as it would require a Fed open market sale of treasury bills: but given the roll-off crisis, foreign investors in US Treasuries are exactly wanting cash (and exiting $ assets) rather than T-bills and thus such a open market operation is effectively unfeasible (unless one spikes massively interest rates, something we will discuss later). Thus, a rollover crisis would take the form of a very sharp dollar fall as little could be done to stop it.
Now, you may wonder what are the chances of a rollover crisis in the US? Again, one of the lessons of past financial crises is that once investors start to lose faith in a country’s currency and its assets, they want to keep the maturity of their holdings of local assets as short as possible to be able to run if a crisis is incipient (see again the case of the Mexican Tesobonos or the Turkish case where foreign investors placed funds in very short dated local currency government bonds). It is indeed the deadly combination of fiscal deficits, large short-term debt and low forex reserves that triggers a currency run and/or a rollover run.
So, what is the maturity of the US government debt and how has this maturity changed over time? We know that a larger fraction of the US Treasury auctions have been recently placed among foreign investors (and 51% of all US government debt is now held by foreigners, an historic high). We also know that foreign central banks hold their reserves in relatively liquid and short term Treasuries as they traditionally prefer short-term assets with limited market risk (i.e. with little risk that changes in long-term interest rates will trigger large capital losses on holdings of long dated-assets).
We also know, from official Treasury data that the average maturity of US government bonds has sharply fallen in the last few years. In the late 1990s, when our budget deficits were turning into surpluses, the average maturity of issuance of Treasuries (i.e. the marginal maturity of newly issued debt) went up from about 50 months in 1994 to almost 90 months in 1999; and the average maturity of the total stock of debt thus increased from about 60 months in 1994 to about 70 months in 2000. But since 2000, things have radically changed: the average maturity of issuance fell from 90 months in 1999 to about 25 months by the end of 2002 to then recover only very modestly to to 34.2 by September 2004 (a much lower figure than its value in the 1970s, 1980s and 1990s) while the average maturity of the total debt has fallen from about 70 months in 2000 to only 55.1 in September 2004.
How to explain such a sharp fall in the average maturity of the US government debt? Of course, with the sharp fall in short-term rates relative to long-term rates in 2001-2003, Treasury found it cheaper to finance itself short term rather than long term. But of course, if the expectations hypothesis holds, there is no free lunch here as long rates reflect expectations of future movements in short rates. More seriously, Treasury has tried to limit the short run fiscal costs of the growing budget deficit by reducing the maturity, and thus the interest bill, of government debt. But, as the experience of Mexico in 1994 suggest, this is a dangerous debt management strategy: issuing lots of cheap short-term debt may seem a bargain but if a rollover crisis then does occur serious trouble can ensue.
Also, it is clear that one of the main reasons for the shortening of the US debt maturity is given by the identity and preference of the holders of this debt: since foreign central banks prefer to hold short-dated maturities in part because short term debt can be disposed of more quickly when necessity or preferences so require, the US Treasury has had to oblige and provide the assets, short dated T-bills, most preferred by foreign investors. Note also that (based on Treasury data), by now 51% of all US government debt is held by foreigners and at least 29% of all US foreign debt is held by foreign central banks. These figures are very large and historical highs for the US.
So, what is the risk of a rollover crisis for US Treasuries? The official conventional wisdom is that such a risk is close to zero as the US has the largest, deepest and most liquid government bond market in the world. That is true but things are a little more complicated. Since the average maturity of US public debt is now less than 5 years (precisely 55 months), in the next few years the US will have to roll over every year hundreds of billions of government bonds that are coming to maturity (about $500 billion in 2005, rising to about $800 billion by 2009 and closer to a trillion by 2014). On top of this large refinancing of the existing outstanding maturing debt stock, the US will every year have additional n
et borrowings from the bond market equal to the US fiscal deficit. That fiscal deficit was $412 billion in fiscal 2004, is bound to be almost as large (based on the data of the first two months of fiscal 2005) in 2005 and could be as large as $1,134 billion in 2014 in a sensible and realistic scenario (the Bush tax cuts are made permanent, the AMT is fixed, discretionary spending grows at the rate of nominal GDP and 2% of payroll taxes are diverted to private accounts in a partial Social Security privatization). So, next year the US will have to rollover over and borrow over one trillion dollar of US Treasuries and by 2014 that fiscal financing need could be as large as $2 trillion a year.
So, while the chance of a full-blown debt rollover crisis are now still small, it is enough that domestic and foreign investors decide to reduce the rate at which they additionally accumulate US Treasuries in their portfolios to have a serious financing problem that would spike interest rates and push the dollar sharply down. Note that, since 2001, net holdings of US Treasuries by US residents have been effectively flat. So, almost all of the net increase in US government debt held by the public has been absorbed by foreign investors (and increasingly foreign central banks). If such investors were to expect a continued depreciation of the US dollar, the expected capital losses on their holdings of Treasuries would be massive. Even a 10% nominal depreciation of the trade-weighted US dollar implies losses as high as $200 billion for foreign holders of US Treasuries. Thus, it is not far fetched to expect that non-residents may want to reduce the rate at which they accumulate US assets and US Treasuries in their portolios. If that were to happen, the dollar would sharply fall, US short, medium and long term interest rates would increase sharply and even the risk of a debt refinancing rollover crisis could not be ruled out. This is part of the “balance of financial terror” that Larry Summers has been referring to. The US is now hostage to the “kindness of strangers” (foreign central banks and foreign investors) for what concerns its ability to finance its fiscal and current account deficits. And, as discussed in previous blogs of mine (here and here) and of Brad, there are good reasons to believe that foreign investors will soon tire of financing the US at these cheap rates if we continue our reckless fiscal policies.
When will this hard landing of the dollar and bond market occur? If the administration fiscal policy goals are aggressively pursued in 2005, there are increasing chances that such hard landing nightmare scenario may occur in 2005 or, at the latest, in 2006.
Is this nightmare scenario far-fetched and too pessimistic? No, if you look carefully at the data, at the US financing needs and the dangerous combination of fiscal and external imbalances, reckless fiscal policy and reckless public debt management (extreme shortening of the maturity of public debt). Again, the lesson of past emerging market crises is that desperate governments start to play accounting games and try to shorten the maturity of their public debt as a way to reduce the interest cost of increasing fiscal deficits. Such maturity shortening is very dangerous as it increases liquidity/rollover risk in exchange for very short-term financing costs benefits, a most dangerous game to play. The same reckless financing policies are currently followed by the US. And the fact that the US can borrow in its own currency rather than in a foreign currency does not qualitatively reduce the risk of a debt rollover crisis: in that case the US may print dollars rather than formally default on its debt (as it would have to if its debt were in foreign currency given the lack of forex reserves to service it) but such monetary financing would be highly inflationary and would lead to a further nasty fall of the US $. In the best scenario, the US would still be able to keep on financing itself, in the middle of a debt rollover crisis, by sharply increasing short term and long term interest rates. That however would imply a severe recession in the US and the global economy.
Am I alarmistic or unrealistic? No if you consider how our reckless fiscal and public debt policies, the absence of adult policy supervision in Washington and mediocre or inexistent US economic policy leadeship will soon lead us to what I referred before as the “Upcoming Twin Financial Train Wrecks of the U.S.“
You have been warned here first..
25 Responses to “Liquidity/Rollover Risk on US Assets? A Nightmare Hard Landing Scenario for the US $ and the US Bond Market..”
brad • December 22nd, 2004 at 1:39 pm
nouriel — no shock, I agree. the shortening of the average maturity of the treasury stock will almost certainly prove to be a mistake. It has kept debt servicing costs down, and thus helped keep the deficit lower than it otherwise would be (but increased the risk that interest costs will shoot way up in the future) And it matched our treausry issuance with at least the BOJ’s preferences (good investor relations? the US listens to its biggest creditors). My limiting the supply of ten years, it also probably kept the ten year rate lower than it otherwise woudl have been, and since the ten year is a reference rate for lots of other borrowing, it helped support the broader fixed income market’s rally — fueling a debt financed expansion. But I at least would have been much more keen to lock in 10 year money for 4% nominal interest rates — the US treasury is supposed to be a paragon of financial prudence, not a debt crazy issuer looking for every angle to minimize its short-term borrowing costs …
Larry • December 22nd, 2004 at 4:12 pm
Note that the BOJ has been extending maturity of their liabilities — ref their issuance of 20 year bonds. Seems a prudent step. Although their circumstances are different, their core debt load is even larger than that of the US.
Billmon • December 22nd, 2004 at 4:49 pm
It seems to me the events of the summer and fall of 1987 provide at least a partial precedent for the kind of rollover crisis Dr. Roubini is describing. The short-term failure of the Louvre agreement to stablize the dollar, plus an abrupt perk-up in U.S. leading inflation indicators led to a fairly massive exodus of Japanese institutional investors from Treasury debt, albeit longer-dated maturies, not T-Bills.(If you look at the Treasury Dept’s chart referenced in the post, you can see the abrupt downward spike in average maturity that this produced.) The end result, of course, was a rip-roaring bond bear market, a stock market crash, an emergency injection of liquidity by the Fed, and – depending on whose memoirs you believe – something close to a global financial crisis in the winter of 1988. On the other hand, 1987 was in the rosy dawn of our new world order of massive U.S. financial imbalances – domestic savings rates were higher, debt loads lower. And, as Dr. Roubini points out, the Treasury had not yet transformed itself into the modern-day version of the Weimer Republic’s Reichsbank. So in the end, the Fed was able to engineer a soft landing, kind of, sort of. Alas, now we’re two decades older, and a hell of a lot more leveraged. Presumably, a good old fashioned run on the T-Bill market would be infinitely more spectacular than the ’87 crisis.(If nothing else, the effect on the monetary aggregates would be truly volcanic.) But if you were alive and sentient back then, and you remember what the world looked like on the evening of October 19, 1987, then you’ve got some idea what’s in store.
L • December 22nd, 2004 at 5:44 pm
Perhaps much of this looks different from an Asian perspective. Note Andy Xie’s prescriptions, almost as if designed to exacerbate the danger Prof Roubini describes: ”First, both China and the US should eliminate negative real interest rates that exaggerate growth rates as soon as possible by raising interest rates by 100-150 bp.” ”Second, Asia should shorten the duration of its dollar reserves as soon as possible. At minimum, Asia should park the increases in their dollar reserves in the money market.” http://www.morganstanley.com/GEFdata/digests/20041220-mon.html#anchor24 He follows his call to shorten maturities and a rate shock with the usual recommendations for Asians to restructure their economies so that they follow standard western models. The painful steps seem possible, their results uncertain. The fundamental reforms seems likely to occur only slowly, with impacts appearing over an even longer period. Does anyone see an easy way out of this box?
L • December 22nd, 2004 at 7:56 pm
When considering the rollover risk, don’t forget our Treasury Bills. In addition to rolling aprox. $500B in bonds next year and selling debt to finance the deficit — we have to roll the aprox $961B in T-bills. Rising rates will quickly flow through to increase the deficit.
Nouriel • December 22nd, 2004 at 8:23 pm
My posting led to an interesting exchange on Brad De Long’s site (http://www.j-bradford-delong.net/movable_type/2005-3_archives/000028.html). He first commented on my posting by arguing: ”I don’t see any possibility of a severe crisis for the U.S. as long as our foreign debt is denominated in dollars or consists of equities. The dollar falls steeply, interest rates rise, the U.S. has a slowdown and (likely) a recession as eight million foreign-funded jobs in construction, investment, and consumer services vanish and the workers have to find new jobs in export and import-competing industries–but the big problems all all abroad. Foreigners and their central banks take huge capital losses on their dollar-denominated assets and find the U.S. market for their exports drying up. It’s our currency, but it’s their problem.” I then replied: ”Brad says that the risk in my scenario of a severe rollover crisis is small if our foreign debt is in our currency and is mostly equities. But, increasingly our foreign liabilities are not equities but rather debt and, increasingly ,public debt (see http://www.bea.doc.gov/bea/newsrel/intinvnewsrelease.htm for the BEA latest report on the US Net International Investment Position). In the 1990s our current account deficit was driven by a real investment boom and the capital inflow that was financing it was mostly foreign equities (FDI, M&A, greenfield investments). But since 2001, our current account deficit has worsned in spite of a fall in investment of 4% of GDP. Why? Our fiscal deficit with our public savings of 2.5% of GDP in 2000 turning into a fiscal deficit of 4% of GDP. So, for the last four years foreigners are financing our budget deficit and most of the increase in the net foreign liabilities of the US is debt, not equities and public debt especially. By the end of 2003, foreign central banks held 1,472 billion of reserves (mostly US Treasuries), other foreigners held 542 billlion of US Treasuries and other foreigners held $1,852 of corporate bonds (a good chunk of which are GSEs, a semi-public for of debt). Thus, out of $ 9,633 billion of foreign liabilities over 2,000 billion are US Treasuries and almost another 2 trillion is corporate bonds. If you add other foreign debt of the US (liabilities of the banking system), only about 3 trillion of the US foreign liabilities are equity (FDI and equity portfolio). So, over two thirds of our foreign liabilities is now debt. Thus, as i already agreed we do still borrow in our own currency (but for how long if we keep on debasing our currency?) while most of our foreign liabilities are now debt, not equity. Also, in Brad’s mild scenario the fall in the US $ should lead to a sharp increase in US interest rates; thus, both traded and non-traded sectors will be hurt by high rates, more so the non-traded but also the traded one. Thus, the ensuing recession will hit both traded and non-traded sector. In other terms, what would US growth be if long rates were now 6 or 7% rather than 4% once foreign central banks stop intervening to prop the value of the dollar?” He then replied: ”Wow! That’s certainly a quick response from Nouriel… Let me put it this way: suppose foreign investors lose confidence in the dollar, and suppose that the Fed’s reaction is, “Our monetary policy is to maintain internal balance: we are going to peg the dollar price of the 10-year Treasury bond at what we regard at an appropriate level.” What happens then? The dollar falls. The dollar falls until foreign investors think, “It’s undervalued. It’s so undervalued that 10-year Treasuries have got to be a good investment.” Are there any negative consequences to that fall in the dollar? Yes–for foreign central banks that find that their dollar interest receipts on their reserve portfolios no longer cover the renminbi payments they owe on the debt they issued to buy their reserves. Yes–for foreign producers who find U.S. demand for their exports dropping like a stone. Yes–for U.S. workers who ship, distribute, and sell foreign-made products. But the big domestic costs would come only should the Federal Reserve allow domestic interest rates to spike and keep them high. And why should the Fed allow that? Should the Fed raise interest rates to keep the value of the dollar from sinking too low? Should the Fed try to engineer a deeper recession to keep a one-time jump in the price level caused by higher dollar import prices from setting off an inflationary spiral? It’s not clear to me it should. It’s pretty clear to me it would not. Thus, as I said, I see a problem for the U.S. economy–and a probable recession–but not a real crisis. Exorbitant Privilege carries the day…” Then, I counter-replied: ”Wow! That’s certainly a quick response from Brad… the Fed directly controls only short term interest rates and any action to stabilize long-term interest rates would be more than unorthodox, it would be an attempt to manipulate long term interest rates that, while not unheard of (Operation Twist in the US in te 1950s or Japanse purchases of long term bonds in the recent Japanese deflation) it would be highly unusual and not consistent with Greenspan philosophy (but Ben Bernanke may think otherwise as he considered such unorthodoxy in fighting deflation). But let us assume the Fed does intervene to stabilize the long rate: domestic and foreign residents are dumping US Treasuries (both short and long) not because they want to hold dollar cash assets; it is because they are trying to flee a plunging dollar. Since the US does not have enough reserve to prevent the $ from collapsing, then the question is whether bond market intervention is a substitute to forex intervention to stop the free fall of the dollar. My answer is not. First, intervening in the bond market is first of all an act of true desperation; it undermines confidence. Second, that action increases by massive amounts the monetary base in the US; it could more than double it or triple it overnite. Third, in a situation in which investors are trying to flee US assets in a rollover crisis such increase in liquidity puts massive further pressure on the US dollar and since the US does not have the forex reserves to stop the dollar free fall, the dollar falls further and the flight from the bond market is further exacerbated leading to even further liquidity intervention to sustain a falling bond market. Then you get both a currency crack and a bond market crack…Again, the probability of such severe crisis scenarios are small and a nasty shock to the bond market is anyhow the pain that the economic idiots in Washington and the White House need to feel to reverse their tax cuts and give up on social security privatization. Thus, bond market intervention is neither helpful nor desirable. I am not saying a severe crisis will occur with certaintly. I am saying that continuing reckless fiscal policies will make it highly likely and force a policy adjustment. That is what we need.” He then suggested the following two scenarios: ”Let’s distinguish two cases: (1) Foreigners decide to dump non-mature Treasuries. There is immediate downward pressure on the dollar, the yen, and the euro prices of Treasuries. The Fed decides to support the dollar price of Treasuries: it buys them for cash. The U.S. money supply goes up. The yen and euro prices of Treasuries collapse–hence the exchange rate collapses. But the U.
S. still roughly maintains internal balance (or does the rising money stock ignite a wave of inflation?) And it seems to me the big problems are outside. (2) Foreigners decide not to rollover mature Treasuries. The supply of dollars spikes on the foreign exchange markets, as foreigners take their dollars at maturity and run. The dollar collapses. The Treasury turns around and needs to find domestic buyers for its extraordinary new issues. The Fed steps in and buys a bunch of Treasuries to keep their prices from falling too much. The money stock rises, but rough internal balance is maintained… or is it? The problem with me trying to think through both these stories is that I think them through assuming that financial markets are in rational-expectations equilibrium. Yet when I look around me I cannot believe that: the dollar is priced too high. The long-term Treasury bond is priced too high.” To which I then replied: ”The two “cases” described by Brad De Long, where the real effects of the dollar crash are dampened, do not appear as realistic. In Case 1, the Fed needs to intervene to support long Treasuries; apart from my previous critique of this, the ensuing collapse of the dollar driven by massive liquidity injection leads to sharply higher inflation and the need for the Fed to tighten short rates. Also, markets may test the willingness of this highly unorthodox Fed manuever to defend a particular long rate (that is causing a truly massive liquidity injections and sharply falling dollar that are both highly inflationary). And in this game of chicken the Fed gives up the defense of the long rate peg sooner rather than later. In case 2, you got a debt rollover crisis on all maturing debt, be it short or long that is coming to maturity. The De Long solution is to fully monetize the whole stock of public debt that is maturing and the one that would otherwise finance the budget deficit. Then, we are talking of liquidity injection (increase in monetary base) of over $1,000 billion in 2005 and much more if the crisis occurs in 20056 or later. Then, base money is liteally exploding (tripling, quadrupling or more), the dollar is then in real free fall and inflation goes through the roof. Note that in all these scenarios you get not just a dollar crash (as you get a currency run http://www.roubiniglobal.com/archives/2004/11/speculative_cen.html) and a bond market crash but also a stock market crash as in 1987. In fact, as very intelligently pointed out by Billmon in a reply to my blog posting: ”It seems to me the events of the summer and fall of 1987 provide at least a partial precedent for the kind of rollover crisis Dr. Roubini is describing. The short-term failure of the Louvre agreement to stablize the dollar, plus an abrupt perk-up in U.S. leading inflation indicators led to a fairly massive exodus of Japanese institutional investors from Treasury debt, albeit longer-dated maturies, not T-Bills.(If you look at the Treasury Dept’s chart referenced in the post, you can see the abrupt downward spike in average maturity that this produced.) The end result, of course, was a rip-roaring bond bear market, a stock market crash, an emergency injection of liquidity by the Fed, and – depending on whose memoirs you believe – something close to a global financial crisis in the winter of 1988. On the other hand, 1987 was in the rosy dawn of our new world order of massive U.S. financial imbalances – domestic savings rates were higher, debt loads lower. And, as Dr. Roubini points out, the Treasury had not yet transformed itself into the modern-day version of the Weimer Republic’s Reichsbank. So in the end, the Fed was able to engineer a soft landing, kind of, sort of. Alas, now we’re two decades older, and a hell of a lot more leveraged. Presumably, a good old fashioned run on the T-Bill market would be infinitely more spectacular than the ’87 crisis.(If nothing else, the effect on the monetary aggregates would be truly volcanic.) But if you were alive and sentient back then, and you remember what the world looked like on the evening of October 19, 1987, then you’ve got some idea what’s in store.” So, we get a triple whammy (http://www.roubiniglobal.com/archives/2004/11/the_upcoming_tw.html): a dollar crash, a bond market rout and a 1987 style stock market crash…Of course, every other risky asset collapses in this scenario as pointed out by my co-author Brad Setser: Housing collapses, corporate spreads go through the roof, emerging market debt collapse and every other risky asset under the sun…. Then, we will have to sell our Treasures rather than our Treasuries as discussed in another recent blog posting of mine (http://www.roubiniglobal.com/archives/2004/12/on_selling_your.html) Sounds too gloomy? In 1987 our fundamentals were much sounder than today both in flow and stock terms…so, this time around “the harder they will fall”…” Many others added thoughful commentary (http://www.j-bradford-delong.net/movable_type/2005-3_archives/000028.html)
Ian A. • December 22nd, 2004 at 11:55 pm
In terms of roll-over risk of short-term securities, don’t forget the Agencies, Fannie Mae and Freddie Mac. Although they strive to maintain a longer debt duration portfolio to match the duration of their mortgage portfolio, a large portion of their liabilities are funded through ‘synthetic’ debt. I.e. instead of issuing a five year bullet debt security to match the duration of a par 30-year mortgage, FNM and FRE will enter into a pay-fix, receive float swap with a maturity of five years funded with a series of rolling discount notes. If you look at the debt profiles of FNM alone, it has close to $300 billion of discount notes it rolls over every three months, in large part to fund this synthetic debt. FRE is around another $150 billion. Plus with another $100 billion from the Federal Home Loan Banks, you are adding more fuel to the fire!
DF • December 23rd, 2004 at 4:16 am
You can also add the risk related to : 1 futures and derivatives market … How will they react to a crash ? Any new LTCM around ? 2 Strange accounting practices. After the recent fanny mae, is there any proof that the Enron-Parmalat era is over ? It seems accounting fraud appear mostly when stock prices fall and liquidity is short … In this you can account strange public accounting practices. Governments worldwide account for a growing chunk of GDP yet not a single government applies private accounting practices. I’m not saying they should, I’m only saying it underestimate their future engagements to pay. You say Brad said ”The dollar falls steeply, interest rates rise, the U.S. has a slowdown and (likely) a recession as eight million foreign-funded jobs in construction, investment, and consumer services vanish and the workers have to find new jobs in export and import-competing industries–but the big problems all all abroad. “ Well I would not call 8 million job vanishing in a recession a small problem. (Especially if it leads to a free fall in housing prices and its direct impact on the value of consumer assets. If their house lose 30% of value will they spend as much …) Well what would be the impact on fiscal deficit of 8 millions of jobs disappearing ? What will be the impact on world wide fiscal deficits of a worldwide recession ? (Think pensions, unemployement revenue that will have to be served)… Once recession strikes …fiscal deficit worldwide will explode, so why would not US citizens buy foreign government bonds ? So the fast answer to Brad is as I guess all roll over crisis have shown. There is a huge chance that we live the last years of free movement for capital. The USA will probably react by regulating the international flows of capital.
DF • December 23rd, 2004 at 5:39 am
Hey Nouriel, I wrote a long post on Brad’s site What do you think of this part : All in all it seems to me that the problem is that free movements of capital have led to a debt ridden world, short in spending. Capital has moved to countries with lower labor costs. Within rich countries wages have stagnated and the ratio wages/value added has diminished too far. Thus spending and investing have only been made possible through reduced real interest rates and appreciating asset prices. No country can afford an increase in wages … No country can afford rising interest rates… (…) there’s no way out : Either real wages increase globally Or a global deflation recession will hit
Steve McQueen • December 23rd, 2004 at 11:15 am
haven’t read through the intervening stuff, but I am now very curious about ‘average outstanding debt maturity’ statistics historically, esp. over a much longer time horizon… can anybody suggest more formal reading on this subject? thanks
Nouriel Roubini • December 23rd, 2004 at 11:29 am
DF, you are right to point out the risk of systemic events given murky derivatives and highly leveraged plays. Also, it is correct to notice that this disorderly hard landing will lead to a US and global recession with ensuing worsening of fiscal deficits. I am, however, not sure that the result of all this will be restrictions to capital mobility in the US or across the world. The problem is mostly not capital mobility or hot money; the problem is reckless policies: this is one of the lessons of a decade of emerging market crises, a lesson that has not been yet learned in the US. Yes, investors panic in a crisis but they do so when fundamentals are already out of line. So, the solution is no to control capital flows; the solution is to fix those fundamental imbalances.
DMS • December 23rd, 2004 at 11:55 am
Very interesting blog entry and comments. I think another reason this could get ugly is the state of US household debt (apart from government twin deficits). From what I understand, a lot is in the form of variable interest rates (ex., half of mortgage debt?), which is very dangerous now since interest rates are almost certainly will have to rise. And all the growth now is on the baks of very low household savings rate (0.2%?). Furthermore, regarding capital mobility, it correct that the right solution to the problem is fix the bad policies. However, imposing capital controls is an easy way for governments to “solve” problems (like protectionism), which the government may be tempted to use. Finally, the Asian crisis had an element of “investor bias/sentiment”; thus some Asian countries took a hit, even though its finances were no worse than Australia or Belgium or Japan. In such cases, capital controls definitely make sense. US has the advantage of not having that problem, yet.
gillies • December 23rd, 2004 at 2:35 pm
‘ you have been warned here first.’ – but only if you are one of those who has never read the novel ‘ the crash of 79 ‘ by paul erdman. gillies
gillies • December 23rd, 2004 at 2:35 pm
‘ you have been warned here first.’ – but only if you are one of those who has never read the novel ‘ the crash of 79 ‘ by paul erdman. gillies
dave iverson • December 23rd, 2004 at 4:37 pm
Markus Brunnermeier and Stefan Nagel have and interesting perspective on “Hedge Funds and the Technology Bubble,” Journal of Finance (2004)59(5). http://www.princeton.edu/~markus/research/papers/hedgefunds_bubble.htm The abstract reads, ”This article documents that hedge funds did not exert a correcting force on stock prices during the technology bubble. Instead, they were heavily invested in technology stocks. This does not seem to be the result of unawareness of the bubble: Hedge funds captured the upturn, but, by reducing their positions in stocks that were about to decline, avoided much of the downturn. Our findings question the efficient markets notion that rational speculators always stabilize prices. They are consistent with models in which rational investors may prefer to ride bubbles because of predictable investor sentiment and limits to arbitrage.” So with much of the world leveraged as never before, including and especially the GSEs: Fannie Mae and Freddie Mac and the banks that hold derivative positions in them — positions that I don’t really understand, but that have many people very nervous in part because the banks, like the American-led financial system at large are in the “too big to fail” category. We seem not to be able to rid our systems of massively corrupting influences (e.g. Enronitis, corrosive politics, crony capitalism, etc.) this side of crisis. So 2005 or later, but not that much later I suspect, may prove to be interesting in sense of the movie Jumanji. We may all have an opportunity soon enough to learn more about the complex and wicked connections of geopolitics, and the bit-parts played by economics and finance.
DF • December 24th, 2004 at 8:01 am
Nouriel, I agree 100 % with you comment on bad policies and fixing fundamental imbalances. But you got me wrong if you think that I said that free capital flows were the short term cause of crisis. I said, free capital flows cause a deflationist environnement : Because capital can move to areas where there are lower wages, capital extracts a larger share of the value added. This is a fact the ratio wages/value added has fallen over the 80′s and 90′s … It is now under the historical norms. My point is that because real wages do not rise, consumer turn to credit has a way to continue to spend. I could add that governments have lost their “taxing power” also because of capital flows. In the end therefore free capital flows are the cause of the structural imbalances. I’m talking here of a long term thing.
DF • December 24th, 2004 at 8:59 am
below my original post. In fact I’m only trying to highlight the fact that external imbalances are related to internal imbalances. 1 Explaining the low long term interest rates : if recession risks are high it is logical that rates remain low… Especially if what is expected is a japan like (and 30′s like) deflation and depression scenario. Some have said the central bank could monetize everything, prevent rising real rates and deflation. So far, the ability of a central bank to face a liquidity trap remains to be proven. If there is a recession : reduced investment, falling housing prices and stock prices … There will be less credit, and therefore less monetary creation. The central bank may try to increase the monetary base, but it will take a long time before it can do so effectively. I can’t see how there could be hyper inflation before an initial stage of deflation… The debt/revenue ratio has to be lowered, worldwide. And the easiest way is through bankrupcies. 2 which leads us to the main question. what will be the trigger of the crisis ? To have a clear view of this all requires to look both at external and internal imbalances External imbalances All the players have an interest in continuing the game. Asians need to export and build their manufacturing base. Europeans also need the american consumer. The USA need finance. All the players would like a smooth adjustment. But that would mean : reducing US fiscal deficit. And this does not seem on Bush Agenda. Europe : increasing demand, may be through more fiscal deficit. Thi is not scheduled. Managing an increase of the remnibi. This has not been on china’s agenda so far. Internal imbalances : Tee problem here is that world wide the ratio wages/value added is falling. Therefore consumer spending can increase only through growing consumer debt-reduced savings. This situation is very true in the USA, true in europe, may be not so much in asia. In fact spending has relied more and more on wealth effect. This is what Roach called the asset economy. The big problem is in the interrelation between external and internal imbalances. Right now US and european companies are awash with cash, they don’t know what to do with it, but they still won’t increase wages … because of asian competition (and lower union power, market policies etc). Everything has relied on ever falling interest rates and ever growing asset value. They have provided the necessary boost to consumer spending. There are two growing imbalances : Consumer debt to banks. (I should in fact talk of overleveradged economies, and include state increasing debt level and the fact that with these low interest rates, many companies borrow and hold assets) US debt to rest of the world. The best scenario requires a world wide strike improving wages in asia and the US thus allowing spending power, boosting investment, reducing debt through inflation… That however is unlikely. So it all comes up to : Internal crisis : consumers stop their borrowing and spending habit. Christmas sales low ? They realise wages will not increase in the foreseeable future. Employment numbers low ? They realise housing prices will fall UK house prices continue their present fall ? They realise their assets are worthless Stock free fall like in 1987 to return to “normal” PER of 14 (instead of present 26) Or. banks stop lending. Increased real interest rates ? External crisis : If the US trade deficit reduces (through falling dollar or recession)… Then if the rest of the world do not increase spending and adjust qualitatively their production, they will enter in recession. Asians and europeans can stop the lending game at any point, fearing the inevitable crisis, fearing others will withdraw before them… US citizens can move out of US bonds and increase the problem. It seems to me the trigger will most probably appear in the internal scene. There’s no way out : Either the ratio wage/GDP increases globally, and this reduces the debt/GDP ratio (less consumer debt, less fiscal deficit and government debt) Or a global deflation recession will hit
dave iverson • December 28th, 2004 at 11:52 am
In a 12/23 reply to DF, Nouriel said, The problem is mostly not capital mobility or hot money; the problem is reckless policies: this is one of the lessons of a decade of emerging market crises, a lesson that has not been yet learned in the US. Yes, investors panic in a crisis but they do so when fundamentals are already out of line. So, the solution is no to control capital flows; the solution is to fix those fundamental imbalances. One question. Why is there so much emphasis on fixing problems after the fact, and so little emphasis on preventive medicine? Years ago conventional wisdom had it that one of the roles of monetary policy was to spoil the party just as it was starting to rock and roll. The idea, I believe, was to disallow irrational exuberance before it got too far advanced, thereby stemming the greed, avarice, selfishness, and other tendencies that lead to Enronitis. Relatedly, the idea was to attack bubbles before they got too big, so that letting the air out of the bubbles wouldn’t do too much damage. I don’t know if anyone was ever good at taking the punch bowl away in practice, but ar least there used to be some talk about it being a good idea. It appears that such alleged prudence is now either blocked politically or has fallen out of favor amongst US monetary policymakers. So we tend to think that we can paper over problems, e.g. “helicopter money.” One more question? In a dynamic, changing world, how does one go about “fixing fundamental imbalances” without addressing the problem of hot money riding bubbles hoping to beat others to hot money prizes and get out before the fall? Paul Davidson and others suggest fixes to the international capital flight problem, but they all have a dose of what Nouriel seems to suggests is not the answer: capital controls. http://econ.bus.utk.edu/washington%20consensus.pdf Did I misinterpret your comment Nouriel?
Nouriel Roubini • December 29th, 2004 at 11:37 am
Dave, you correctly interpreted my comments. I am no fan of capital controls even if, at times, fickle investors and hot money, can exacerbate the effects of a fundamentals driven crisis. Anyhow, the problems with the US reckless policies is that there are no Bond Market Vigilantes, i.e. not enough “speculators” (rather than too many) ready to pull the plug from the US bond and currency markets. I wish there was more hot money to discipline the US policies; unfortunately, so far, foreign central banks are not playing the vigilante role they should. So, paradoxically we need more capital mobility and more private capital flows in a sense….
Jim B • December 29th, 2004 at 1:04 pm
The potential for rollover risk that you site is very thought provoking. The questions that I have are, are the banks, investors and bond traders hedging their risk against such an event? If so, what kind of deriviatives would they be buying, and if there are large amounts of such derivatives being sold, wouldn’t that compound the problem? ie, what are the chances of a derivatives melt down?
DF • December 29th, 2004 at 1:24 pm
Nouriel, you did not adress the point I raised : GIven capital is more mobile that labor, it is natural that unregulated capital flows lead to a lower wages/gdp ratio. When capital is allowed to move abroad it extracts more out of the growth. This is exactly what we’ve seen these last 20 years. Real wages have stagnated, profits have risen, inequalities have risen. You must agree with that. Now don’t you think this is the main reason of the falling interest rates and the growing indebtness of consumers ? As real wages stagnate the only engine for growth can be increased debt. Capital controls are needed not because they cause financial instability but because they create economic inequalities that lead to higher level of debt
Nouriel Roubini • January 4th, 2005 at 9:31 am
DF, i beg to disagree on your analysis. In many parts of the world real wages and real incomes have increased for the last 20, 30, 40 years. Billions of folks in China, Asia, India even Latin America are better off today than they were 30 years ago. So, I do not buy this arguments that real wages have stagnated. Even in the advanced economies and the US things are more complicated. But this is a long and complex issue that cannot be resolved with a few lines. Also, basic trade theory suggest that trade and capital mobility increased real wages and reduces the returns to capital in labor abundant countries: that is why globalization has benefitted large parts of the world. This may not sound as very PC but trade, globalization and even capital mobility is the main source of income growth for the poor masses of most of the developing world…Martin Wolf in his book on Globalization is the most compelling recent explanation of such points.
DF • January 6th, 2005 at 6:07 am
I agree with you in most asian countries. Wages have increased. But I bet wages get a low part of the value added. This is why their growth rely on exports. They can not buy everything they produce. Globally, wages got less of the value added. There’s no doubt poor asian masses got closer to the western masses. Latin american fared a bit better and africa is really a mixed case. May be I spelled it out more clearly in brad’s blog : 1 Let’s say there’s a wage equalisation process. If you’re a manager, you are shopping for labor world wide and thus increasingly equalise wages. That’s OK. That means wages should fall in rich countries, raise in poor ones. 2 Meanwhile, wages may rise because of productivity, and world wide division of labor may help increase productivity. So all wages are up. 3 But there’s a third factor. As a wage equaliser, shoping for labor, you make a margin. Just as any retailer. This margin goes into increased profits. And no doubt profits have risen faster than wages world wide. If they had not, how would you explain the asset bubbles. Real wages world wide increase. That’s OK. But Profits increase faster. And on the long run that’s the problem. Because there’s not enough demand. Spelled otherwise : there’s a real side to any monetary phenomenon. If you increase the monetary stock, you can get inflation in consuming good prices or in asset (production goods) prices. What makes the balance shift ? My bet is that its the pricing power of workers. If wages go up as a percentage of value added, profits fall, inflation (of consuming goods) rises. If wages go down as a percentage of value added (they can still rise in real wages), inflation (of consuming goods) stays still, asset prices rise and rise. This is what we’ve seen. The main problem is that OECD stats show rather sunchanged wage/Value added ratio for the USA. I suspect that it’s because of imports. If you produce parts cheaper abroad and import them, the USA company makes bigger profit, with a lower value added. Wages stay the same as a % of the value added. The more they import, the bigger the profits. Gee I have a hard time to make sense out of it. Now let’s see the Rest of the World (RTW) : its value added increases a lot. But profits stay low, as they invest a lot to keep increasing production. Right now, I d end up thinking, the USA (and western) companies are siphoning profit from foreign companies. They are on a low growth, huge profit path, while asian companies are in a huge growth low profit path. Once the dollar falls in relation to asian currencies, the international division of trade may take another look. If you’re nike, you import low priced remnibi shoes (60% of final worth), and sell your advertising job in big dollars (40%). You make a huge profit. Then you have to import high priced remnibi shoes (jumps to 66%) and sell your advertising job in low dollars (falls to 34). You have to squeeze your belt to keep the same overall price. I was also thinking, since Value added approximately equals wages in lots of services, especially administration, health, then as these sectors have grown, the share of wages should have grown, it has not.
DF • January 6th, 2005 at 8:51 am
OK I did some homework, went on the oecd website, downloaded some stats, and here are the figures : During 1990-2004, if you compare real wage growth to labor productivity growth here is what you get : US : -8,3% Europe : -9,2% Japan : -25% For the 80′s you get : US : 0,7 Europe : -0,7 Japan : -0,3 I don’t have longer series but I’m sure I would find positive numbers in the 60′s -70′s. I don’t have the numbers for asia, but I bet they are negative for the period 1990-2004
DF • January 6th, 2005 at 8:59 am
here is the link to play with figures by yourself http://www.oecd.org/dataoecd/5/47/2483871.xls OK I did some homework, went on the oecd website, downloaded some stats, and here are the figures : During 1990-2004, if you compare real wage growth to labor productivity growth here is what you get : US : -8,3% Europe : -9,2% Japan : -25% For the 80′s you get : US : 0,7 Europe : -0,7 Japan : -0,3 I don’t have longer series but I’m sure I would find positive numbers in the 60′s -70′s. I don’t have the numbers for asia, but I bet they are negative for the period 1990-2004 exceptions to the trend are Iceland, spain, portugal and UK…
