This post is a contribution from Rob Parteneau of MacroStrategy Edge about fiscal expansion, printing money, avoiding debt deflation, and U.S. treasuries. He has some great insights on deflationary spirals, the paradox of thrift and the desire of foreign investors to dump dollars. He also argues that the “Blame Asia Meme” is misguided as the ultimate source of credit growth in the United States is domestic. The crux of his statements is that the only way to avoid a deflationary spiral when household savings is increasing is through fiscal expansion, which is one reason I support fiscal stimulus. But, there are consequences.
Rob is a CFA, research associate at the Levy Economics Institute and the sole proprietor of MacroStrategy Edge, where he uses macroeconomic insights to inform U.S. equity and global balanced-portfolio strategy. He also serves as editor of the monthly Richebächer Letter, which was started by the lovely Kurt Richebächer,a well-known Austrian economist. For more information about Rob, visit: www.levy.org/vauth.aspx?auth=363.
Here’s what he had to say in an e-mail:
Remember with a flexible exchange rate, capital inflows have to equal the the current account deficit. Dollars flow out through the trade deficit (which is a large part of the current account deficit) as the US spends more on imports than it earns on exports. Those dollars are net saved by our trading partners and they are reinvested in dollar denominated assets. If portfolio preferences of foreign net savers shift away from holding US dollar denominated assets, asset prices have to adjust until they are willing holders of the dollars they earn in trade (that is, interest rates must rise, equity prices must fall, until expected returns are attractive enough for foreigners to maintain their US dollar holdings). Also, if foreign net savers of dollars favor particular assets, like US Treasury bonds, for a variety of institutional reasons, then relative US asset prices can also be influenced.
The money that flows out through the current account deficit flows back in through the capital account. For a nation with a flexible exchange rate, there is no change in the money supply from trade activity. This is just the opposite of a fixed exchange rate system, of which gold based systems are one type, and that is why James Grant advocates leaving flexible exchange rate systems in the dustbin of history. In a fixed exchange rate system, money balances of trade deficit nations are drained off to the trade surplus nation, and the trade deficit can only be run until the existing money balances of the trade deficit are exhausted.
Neither foreign private or public entities can create US dollar reserves out of thin air. That is the charge of the US central bank and commercial banks. Foreigners have to earn dollars from sales of goods or assets to US dollar holders.
That means the ultimate source of the credit to support US trade deficit spending could not have come from abroad. Rather, credit was created in the US as households engaged in mortgage equity withdrawal during the housing boom, and spent more than the earned. Neither foreign savings nor foreign capital inflows were required to create this credit. All that was required was a household willing to borrow with identifiable equity in their home, and a bank willing to expand its balance sheet, with new home equity loans creating new deposits out of thin air. The loan is made, which shows up on the banks asset side of the balance sheet, and the homeowner has a credit line it can draw down, which shows up on the liability side of the bank balance sheet. Nobody here or abroad needed to save beforehand for this money deposit and credit loan to be created.
So what happens when the housing bubble bursts? Equity in homes shrinks, mortgage equity withdrawal shrinks, bank balance sheet growth reverses, household deficit spending reverses as they begin to net save, the trade deficit begins to turn, foreign net saving is reduced, and foreign capital inflows to the US are also reduced. The trade deficit is the twin of the household deficit spending, and the household deficit spending was made possible by credit expansion by US financial institutions on the back of the housing bubble.
In other words, foreign saving and capital inflows are at the tail of the dog, not the head. The only way the tail wags the dog is if foreign portfolio preference shift suddenly or persistently against US dollar denominated assets or specific US asset classes, in which case asset prices must adjust to keep foreign investors willing holders of US dollar denominated assets. We must always be careful to distinguish between shifts in preferences with regards to existing holdings, and shifts in saving out of income flows. The two are not the same, but they often get conflated.
That is not to say the threat of foreign investors dumping US assets isn’t a danger, but it may not be the central risk. The central risk is that the US private sector is shifting to a net saving position in a dramatic way for the obvious reasons – loss of wealth, precautionary saving given recession, etc. Arguably, this needs to happen if households are going to pay down debt and reduce debt burdens, and if they are realizing capital gains are not guaranteed.
The risk of this necessary adjustment arises because if the private sector moves to a net saving position – spending less than it earns – the income level in the US will fall unless the trade deficit turns quickly enough, and unless the fiscal deficit expands commensurately. For every net saver, there must be a net deficit spender, or else the net saving cannot be accomplished without an adjustment of incomes. This is where the so called paradox of thrift comes from. If incomes fall, debt defaults and delinquencies will increase more dramatically, and there is a good chance of heading into a debt deflation spiral, a la Irving Fisher.
In Q4 2008, US nominal GDP fell. Incomes have started to fall. That indicates the private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date.
From a US only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit. But in a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade. The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit. As the government spends more than it earns in tax revenue, private sector incomes are boosted, and the private sector can earn more than it spends. They are two sides of the same coin. In that sense, if you agree private sector deleveraging is necessary part of the adjustment process, or at least important, it comes at the price of public sector releveraging, barring a heroic reversal in the US trade deficit (which would throw our trading partners into an even more severe recession unless they also pursued domestic demand led polices, a la China).
To illustrate this, the current account deficit has already gone from about 6% of GDP to 4% of GDP. Let’s say further consumer and inventory contraction gets us to 2% of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12% of GDP. That means the private sector can net save 10% of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9% of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process.
So can the foreign trade and US household spending imbalances be adjusted? Yes, they can. Does that adjustment process create further challenges? Yes it can, to the extent massive fiscal deficit spending is required to allow the private sector to accomplish its net saving objective without cratering private incomes and setting off a debt deflation spiral.
Then the question really boils down to, can the massive Treasury bond issuance be placed, especially if a smaller US trade deficit means foreign investors have fewer dollars to reinvest in US assets?
Treasury bonds were once 40% of commercial bank balance sheets. They were below 1% last I checked. Default free securities might look attractive to banks these days, especially with a positively sloped yield curve. The Fed used to hold 70-80% of its assets in Treasuries, now down to 20%. The Fed will want to have plenty of Treasuries to sell into the market once the eventual recovery comes and private investor liquidity preferences fall… Remember, the Fed has no budget constraint.
Does this imply an increase in liquid assets in the economy? Yes it can, but we are also undergoing a large financial sector deleveraging, and we have begun a household sector deleveraging as well for the first time in the post WWII period. As loans are paid backed, deposits are cancelled out, shrinking conventional measures of the money supply. Much of the credit in the shadow banking system has been obliterated, and will not be coming back soon.
Is there nevertheless a risk of a flight from the dollar to the extent the US is willing to be the first mover, and an aggressive one at that, down these paths of quantitative easing? Yes there is. Is there a risk investors seeing the more central banks pursing the quantitative easing path will take flight into precious metals and other real assets as prospective inflation hedges, even if product price deflation is showing up in more countries? Yes there is. Could that complicate the policy exit strategy to the extent some of these commodities, like oil, are inputs to production, and so higher commodity prices could lead to an adverse shift in supply curves (to the left in price/quantity space, as in stagflationary periods)? Yes it could.
My reaction to all this concerns or monetary system, dubbed by many “Bretton Woods II.” It is a volatile and unstable system which has been an enabler of bubbles and crashes since it was begun in the early 1970’s. Now, we are at critical juncture.
WIth the G-20 coming up next week, it bears remembering that a large part of what these conferences could accomplish is stabilizing our global financial and monetary system. Recent comments by leading figures in China and the United States has reinforcd the sense that the status quo is not stable. Along those lines, I published excerpts from a paper by Paul Davidson, a leading scholar in this area (”Paul Davidson: Reforming the world’s international money“). Judging from recent comments from Barack Obama, the United States is open to Davidson’s ideas.
As for Rob, there is a good Levy Institute paper he wrote in November 2006 that early on outlined the results of the housing bust on the ability of households to deficit spend and on the prospects for the US economy.
There is also audio of his presentations at the past two Minsky conferences held at the Levy Institute. The 2007 Session 1 audio, in which Rob presents in the second half, may be particularly useful as it laid out the roadmap for the current global crisis in advance. In the 2008 conference audio, he appears midway in session 2 and update the outlook.
He will be speaking at the Levy Institute’s Minsky conference in NYC in two weeks if anyone wishes to catch the live update!
Originally published at Credit Writedowns and reproduced here with the author’s permission.