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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 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 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 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 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 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 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 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? 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 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 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 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 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 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 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 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? 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 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 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 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. 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. 78 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 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 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 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) 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 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 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 97 Reserve accumulation hel the Renminbi undervalued, and helped maintained the low the cost of inward FDI. current account surplus 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 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 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 103 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. 105 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. 106 The Dollar Strengthening Flight to safety into US treasury bills– backed by US taxpayers. Dollar as a Reserve Currency 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 109 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. 110 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. 111 Oil Producers’ currency pegs stick 112 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 113 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 114 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? 115 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? 118 Answer, in part, is US government. Medicare and medic aid(majority of it goes to elderly) Global imbalances 119 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 120 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. 121 ..\Documents and • Settings\Razin\Desktop\Picture1.jpg.emf US net external Assets turn negative: Short term liabilities exceed corporate stock and direct Investment on the assets side. 123 • 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?): 124 125 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! 126 127 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. 128 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. 129 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? 130 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. 131 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. 132 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. 133 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. 134 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. 135 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. 136 Historically, 31% of the international 137 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. 138 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!