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December 22, 2004

Rollover Crisis?

Nouriel Roubini makes me look like a real optimist.

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.

Nouriel, however, sees a very, very different scenario as likely:

Nouriel Roubini's Global Economics Blog: December 2004 Archives: 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....

[R]ollover risk is high if the short term liabilities are in a foreign currency and the country has limited short-term foreign assets... In the case of the US... its domestic government debt is in local currency... 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)... 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... 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.... [I]n 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....

[O]nce 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.... 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.... [T]he average maturity of US government bonds has sharply fallen... 70 months in 2000... 55.1 in September 2004.

How to explain such a sharp fall in the average maturity of the US government debt?... 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.... [O]ne 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... 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.... [But] 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).... [T]he US will every year have additional net borrowings from the bond market equal to the US fiscal deficit... $412 billion in fiscal 2004... almost as large... in 2005 and could be as large as $1,134 billion in 2014.... 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....

[S]ince 2001, net holdings of US Treasuries by US residents have been effectively flat... the net increase... 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.... 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.... 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..

Posted by DeLong at December 22, 2004 11:00 AM

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On a positive note this will make lovely course materiel for your Economics class.
Wot! no Elaine?

Posted by: big al at December 22, 2004 11:11 AM

big al, It's going to make for a good history class too, because we will be living in what the Chinese call "Interesting Times">

We are #$%@ed.

Posted by: Matthew Saroff at December 22, 2004 11:24 AM

Foreign central banks hold US Treasuries because they want dollar expensive and their currency cheap because they want to industrialize. Maturity of US Treasuries is not a problem - deindustrialization is.

Posted by: a at December 22, 2004 11:50 AM

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?

Posted by: Nouriel Roubini at December 22, 2004 11:54 AM

So why are interest rates so low? Where is the reaction to dollar depreciation? Why aren't investors demanding higher returns to balance these risks?

Posted by: Dave Johnson at December 22, 2004 12:12 PM

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...

Posted by: Brad DeLong at December 22, 2004 12:23 PM

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.

Posted by: Nouriel at December 22, 2004 12:48 PM

Thanks to Dr.s DeLong and Roubini for a cogent discussion as to their differences.

Posted by: Matthew Saroff at December 22, 2004 12:59 PM

No one has answered Dave Johnson's question in today's weblog. Why are interest rates staying low, if there are high risks?

To say it another way, why would Asian central banks ever dump the dollar if it would cause such a worldwide catastrophe?

Posted by: Steve Bodner at December 22, 2004 01:06 PM

Interest rates are presumably staying low because lots of people think the break is still a ways away, and think they'll see it coming and be able to sell before the crunch.

If there were just one Asian central bank, it probably wouldn't ever dump the dollar. But there are at least four with huge positions. And then there are the European investors who hold dollar-denominated assets, who will one day decide that they would rather that Asian central banks were the ones bearing the risk of a dollar collapse...

Posted by: Brad DeLong at December 22, 2004 01:17 PM

Brad: Interest rates are presumably staying low because lots of people think the break is still a ways away

Industrialization of China etc. + US as primary consumer
-> Need for China etc. for cheap local currency and expensive dollar
-> Asian banks holding and buying lots of dollar-denominated debt
-> Low interest rates in US

The rate of slide will correlate with domestic demand in China. But there is a lot US goverment can do to muddy the waters - muslim separatism, Sino-Russian tensions in Far East etc. (Not that I approve)

Posted by: a at December 22, 2004 01:39 PM

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.

Posted by: Brad DeLong at December 22, 2004 01:54 PM

The strongest argument for a spectacular ending to this particular financial drama is simple, and it's political, not economic. To wit: Given that the party currently in control of the U.S. government has made the free lunch its central organizing principle, the U.S. fiscal balance will continue to deteriorate until there is a whopping big crisis. Therefore, anything the Fed and/or the Asian central banks do to postpone or ameliorate the situation (propping up the dollar, Operation Twist II, etc.) will only ensure that the crisis, when it finally arrives, will be all that much worse.

The last exit leading to a non-Argentine solution was passed on November 2.

Posted by: Billmon at December 22, 2004 03:05 PM

Of course, I'm assuming that there is some degree of dollar depreciation and/or money supply growth that is so catastrophically large it destablizes the domestic financial markets, making it impossible to maintain internal balance. If so, I strongly suspect we will get there sooner or later.

Posted by: Billmon at December 22, 2004 03:11 PM

A few thoughts:

1) re: dave's question: Why is the long-bond price so low? I have talked myself into believing it is mostly due to official policy decisions -- Treasury shortening maturities and thus reducing supply, and Asia buying enormous sums of fixed income dollar securities. In 2003, the total increase in dollar reserves ($420 b + 40b that China used for bank recap) exceeded the increase in overall Treasury supply. Not all $ reserves go into treasuries but a lot do, and not just at the short end of the treasury curve. As a result of all this official buying, the absolute size of US private holdings of treasuries has stayed constant despite the growth in overall treasury stock, meaning that US (mostly private) holdings of treasuries have fallen v. as a percent of total financial assets/ % of GDP. The $ reserve increase in 04 looks to exceed the $ reserve increase in 03 ... once, again, that creates demand for treasuries, helping keep prices high/ rates low --

2) Prof. Delong -- there are different adjustment scenarios for the US. The one Martin Wolf lays out right in the FT implies the current account deficit remains at 3% of GDP over time, so the US still needs to attract net capital inflows. It is hard to for me to see how that happens if the Fed responds to the dollar's fall by loosening to preserve US output. If that is the case, the current account deficit needs to go to zero, which implies a trade surplus (assuming that the foreigners who do still rollover their short-term claims rather than rolling them off demand higher rates, whether explicitly on short-term debt or implicitly to keep on holding their longer term assets -- so there is an income deficit). A bigger adjustment in the US implies a bigger shock in demand to the world, which then feeds back into reduced demand for US exports. If foreigners wanted to run down their stock of US assets as well, not just stop adding to them, the US might even be forced to run trade surpluses to (slowly) pay down its existing debt stock. Sounds extreme, but it is not completely inconceivable, depending on the US policy response.

3) I would reinforce your last point -- the scenario you sketched out implies a broader repricing of all fixed income assets, not just treasuries. Mortgages, corp bonds, junk bonds, etc. There likely is a fall in the market value of existintg long-term debt/ housing stock -- it seems hard to have a one off change in the price level w/o creating some expectations of future changes, or at least leading investor holding fixed income assets to demand compensation for more "uncertainty" or something. That wealth effect in turn has impacts on the real side of the economy.

Posted by: theotherbrad at December 22, 2004 03:11 PM

Brad: Let's distinguish two cases

How is selling part of your bond holding before maturity different from letting a portion of your bond portfolio mature and not reinvesting it?

The key is not mechanism but speed - the currency run (when, say, 5% of Treasuries are sold in one day) is extremely unlikely. The relatively slower dynamic of dollar depreciating because of low interest rates and trade deficit is the actual scenario. Like I said above, the industrial policy of Asian countries is what limits the rate of dollar slide.

Posted by: a at December 22, 2004 03:22 PM

I think we might be looking at things in the wrong direction here. There has been repeated financial crisis in the 1800's basically every 20 years from 1840. The crisis in the 1870s and 1890s were pretty bad, as I heard tell--for the British. There was a lot of damage done the British economy during those years, and debt was sorta denominated in sterling. Boer War didn't help either.

But look at it this way. Brits have lost their shirts attempting to speculate in America during the last half of the 19th century. The repeated financial difficulties made the US a bad debt risk in british eyes. However, they kept trying again, as the US was definitly a growing economy, soon to eclipse them.

Now think of it with U.S. vs China or other emerging manurfacturing powerhouses. It is hard for me to reject the notion that China views the currency intervention as something other than a sunk cost. I am thinking China is essentially paying for manurfacturing capaciy, not investing in dollars. To be more explicit, I am not sure the Chinese truly will care if they take a huge loss on dollar currency--it's largely gonna be the sanitation process at the end that helps deal with the inevitable inflation as the renmimbi floats. This instead of the typical version of currency sanitation.

I would put money on that China is the first to disengage. What Mr. Delong is talking about is more or less Japan who cannot afford a dollar devaluing.

Posted by: shah8 at December 22, 2004 03:25 PM

Evidently the market does not think that Asian central banks will abandon their weak currency policies anytime soon. I have not seen any argument that suggests they are near their break point.

Given that Japan is still flirting with recession and deflation, and interest rates there are near zero (hence the return they receive from Treasuries is higher than they would receive in Yen-denominated bonds), they will continue to buy dollars to keep the Yen from appreciating drastically.

China, Korea and Taiwan will also keep their currencies cheap, buying dollar-denominated Treasuries and US agency (mortgage) debt. BoK just intervened in the last couple of months and talked openly about an "understanding" between PBoC, BoJ and BoK on this matter. It is Bretton Woods II until this understanding unravels, with the euro bearing most of the pain until the ECB caves in and starts buying dollars too.

US hedge funds are seeking return, and willing to take big risks in the carry trade to get it. Their time horizons are short - if they think a currency meltdown might be a year or years away they will still be in the game.

Martin Wolf in the FT today emphasises the key role Asian economies play in the current imbalance:

Posted by: steve at December 22, 2004 03:25 PM

While Nouriel is concerned about his nightmare scenario, and rightfully so, in reading his work it is clear that it is not a foregone conclusion that the dollar will crash. There are many fiscal and monetary steps that could be taken to avoid it. By all means, monetizing the deficit as Brad suggests, or not taking steps to reduce the deficit, would be playing with dynamite.
I think that given the low funding rates, risk of recession, and support from foreign central banks, long-term treasury rates are not too low. The Japanese, Europeans, and most others can always hedge their FX risk away, but the US-based returns should be evaluated on their own merit. Don't confure interest rate risk and FX risk.
That said, a withdrawal of support for treasuries causing a spike in yields (even if the Fed steps in afterwards in a heterodox manner) could cause balance sheet problems in the US due to the leverage in the system; even with low rates after their could be a credit crunch, etc.

Posted by: Uber at December 22, 2004 03:37 PM

The two "cases" described by Brad De Long, where the real effect 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"...

Posted by: Nouriel Roubini at December 22, 2004 03:50 PM

Two questions:
1. Won't some assets do well in this hyperinflation scenario (gold? real estate?)?
2. As to all the various projected crashes, which asset classes will do better, relatively?

Posted by: Bill at December 22, 2004 05:36 PM

"As to all the various projected crashes, which asset classes will do better, relatively?"

In a best-case scenario: The Swiss franc.

Worst case: Armored humvees, RPGs, Ak-47s, canned food. Maybe gold bullion, if you have enough firepower to guard it.

Posted by: billmon at December 22, 2004 05:54 PM

Shah8 writes: "I am thinking China is essentially paying for manurfacturing capaciy, not investing in dollars. To be more explicit, I am not sure the Chinese truly will care if they take a huge loss on dollar currency--it's largely gonna be the sanitation process at the end that helps deal with the inevitable inflation as the renmimbi floats. This instead of the typical version of currency sanitation."

Or, maybe what's behind door number 3: "As it turned out, though, the safeguards weren't necessary. Apparently wishing to avoid a conflict with the United States, the Chinese government announced that instead it will impose an export tax on textile shipments. Exactly what those export tariffs will look like, and their effect on the flow of Chinese clothing and other textiles to the United States, isn't known. The Chinese government has been pointedly nonspecific about the numbers and other details."

It may be possible for the Chinese government to have its cake and eat it too. By raising export tariffs, the government can offset the inflationary pressures of the RMB/Dollar imbalance, but by carefully playing the demand curves of the various components of the export base, they can avoid the across-the-board hit to manufacturing that a straight-up currency revaluation would entail.

Posted by: Michael Robinson at December 22, 2004 06:29 PM

"by now 51% of all US government debt is held by foreigners."

The 51% is of the “privately held” federal dept, so doesn’t include what I think is referred to as “agency debt.” I often see the 51% number cited.

Can someone informed on the subject please explain why the percentage of the federal debt owned by foreign interests is expressed only as a percent of the privately held debt?
Why isn’t the agency debt counted as federal debt?

Posted by: Chrisb at December 22, 2004 06:53 PM

chris b

there are two major categories of public debt

market debt, or debt held privately

and debt held by various government trust funds (social security, military retirement).

the debt held by the trust funds is usually excluded from the reporting -- both because it is "off budget" in the federal government's accounts (the trust fund's surplus cancels out part of the general funds' deficit, etc) and because the bonds held by the trust funds are not traded in the markets (they are structured in a way so that they cannot be bought and sold).

the bureau of public debt has a useful web page that reports both the debt held by the public (market debt, privately held debt, there are lots of terms) and debt held by the trust funds.

Agencies are a bit different -- agency bonds are the bonds issued by quasi-governmental agencies like Fannie Mae (federal national mortgage something or rather )which have a complicated relationship with the federal government. That is too complex a subject for this comment. Plus, others understand it better than I.

Posted by: brad at December 22, 2004 09:16 PM

This has been such a good thread - it even lured Billmon out of his bunker. Thanks to DeLong and Roubini and everyone else.

Posted by: Tom DC/VA at December 22, 2004 10:18 PM

This blog is a real education to an economic semi-literate like me. However, when I read the phrases "soft landing" and "gradual", I start rereading my chaos theory library and wondering which butterfly in which jungle is going to set it off.
"Tipping point", musical chairs, other metaphors come to mind. I just don't see the denouement of the US administration fiscal policies being any too rational or gradual.

Posted by: Richard at December 22, 2004 10:29 PM

Whether the US govt is ultimately responsible for Agency debt is unclear. People like Greenspan are in favor of making it clear that there is no Federal guarantee behind Fannie and Freddie.

In any case, Agency debt is just repackaged mortgages. By buying Agency debt, the PBoC is keeping mortgage interest rates low in the US.

Posted by: steve at December 22, 2004 10:33 PM

As reckless as Bush co continues to be with our Chinese banker friends' (self-interested) generosity, given Asia's dependence on the American consumer, why would Asian central banks begin dumping dollars like so much toxic waste when (in addition to potentially catastrophically destablizing the world financial system) it would dramatically drive up their respective currencies, and in turn the cost of goods from their respective countries.

It seems logical to me that the trigger would probably have to be domestic, and likely take down American consumer spending first (which is really the only card America has left to play with our export-centric Asian creditors.) A housing collapse might do the trick, as might another massive terrorist on American soil.

Posted by: David at December 23, 2004 12:20 AM

The US, and world economy, has been in decline since the 70's. We are living in the a slow-motion collapse, and given the size and diversity of the US economy, I doubt we will have a sudden Argentinian meltdown.

Rather, we will have what we are experiencing - a long decline/stagnation in real wages, increasing debt load - with more industries and countries being bailed out with taxpayer money.

A national feeling that our children will not lead better lives than us.

The only way to combat that is the long-term political reeducation of our peers - not heroes, or a depression which might "wake people up".

Posted by: jeff at December 23, 2004 01:28 AM

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...

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 monetizing everything. 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 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.
Managing an increase of the remnibi. This has not been on china's agenda so far.

Internal imbalances :
THe problem here is that world wide the ratio wages/value added is falling.
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)

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 wages, then, 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.

But there's no way out :
Either real wages increase globally
Or a global deflation recession will hit

Posted by: DF at December 23, 2004 02:34 AM

"As democracy is perfected, the office of President represents, more and more closely, the inner soul of the people. On some great and glorious day the plain folks of the land will reach their heart's desire at last and the White House will be adorned by a downright moron."

H.L. Mencken

The United States is running a dangerously risky venture into economic fantasyland (I guess that is what economics really is anyway). Still we are firmly set on a blind path to both ever increasing debt and deficits with no prospect for a turnaround in sight. The complete lack of policy by this administration and the congress to enact even the smallest repairs to this situation is alarming to say the least. As Government spending increases ever higher and tax reciepts remain too slow to catch up, what will happen in a few years from now when we have to raise the debt cieling to 15 trillion because of our horrid policies and the sinking dollar. I have heard that Bush is asking the Pentagon to cut back it's non war budget a percent or something (Bravo monseigneur). However, Bush's major priority this term seems to be to privatize social security, which will even further increase the debt burden in the next 15 years. While we did survive the Stock market bubble burst of 2000, will we be so lucky with the real estate bubble? You must remeber we had just come off the largest growing economy in history with surplusses to throw around. That is certainly not our situation now. "Reagan proved deficits don't matter", Chaney said. I guess we are all going to find out pretty clearly in the next few years wether he is right.

Posted by: eric at December 23, 2004 03:35 AM

Thanks Brad and Steve for the primer on the classifications of federal debt.

Posted by: chrisb at December 23, 2004 05:26 AM

"As democracy is perfected, the office of President represents, more and more closely, the inner soul of the people. On some great and glorious day the plain folks of the land will reach their heart's desire at last and the White House will be adorned by a downright moron."

H.L. Mencken

Hallalujah! We've reached the promised land!

Posted by: Billmon at December 23, 2004 08:03 AM

billmon, i miss you :-(

Posted by: sampo at December 23, 2004 10:52 AM

This has all been very interesting. What seems to me is hapening though is that everybody is looking at short-term policy decisions by various central banks. And that's all very important. But what I'm more curious is what people, namely Brad and Nouriel, think about the long term state of things. In the short run banks may be able to control currencies and interest rates. But in the end there should be a natural rate that real interest rates should be heading to, correct? And, given the expansion of the money supply, there should be a natural rate that inflation is heading to, yes? So while it is interesting how we get to the long run equilibrium, what I'd be more interested in hearing is where we are relative to the long run equilibium, and why.

Brad says that exchange markets are not in a rational equilibrium, so he must have some view about where the currncies must go in the long run and why.

Posted by: Ian D-B at December 23, 2004 11:08 AM

The countries not subject to original sin will step forward and claim the debt.

Posted by: cloquet at December 23, 2004 12:24 PM

Hmmm...I wonder if it will be Alan Greenspan or his successor who has to deal with the problem? That could make all the difference.

Posted by: Randolph Fritz at December 23, 2004 11:24 PM

Folks, DF has it right. Inflation is not in the cards in the US. The U.S. and in fact most Modern Economies are in a long-term deflation/disinflationary period that will/is being marked by rolling recessions followed by weak recoveries.

Every market barometer is telling us this, but nobody cares to pay attention to Mr. Market.

I find it amazing that so few pundits care to make this conclusion several years into massive twin deficits and a pretty good depreciation of the dollar. If interest rates were going to rise, they would have already given that we are technically 3 years into recovery. The market is not "wrong" or "stupid" for this long.

The deflationary pheonom is partly caused by the giant sucking sound of over 1 billion Chinese and Indian workers in both the manufacturing and services industry willing to work at 1/20 the wage and same productivity level. It will take years if not decades for some type of global parity on this front.

It is further exacerbated by the enormous leverage of the American/British/Australian/Industrialized Nations consumer caused by the equity and real estate bubbles. Bursted asset bubbles, when delevered, are a major headwind to Aggregate Demand. This is particularly true given the amount of leverage in the system. This is why the British yield curve is inverted at only 4.5% and the Australian yield curve is flat; look for the same thing to happen here around mid-year at levels under 4% (10yr UST).

The conclusion is that the only way to correct the imablances is by a massive recession (s) because the Asians have no vested interest in breaking their peg and the middle class US consumer is tapped out; this year's weak Christmas retail sales is yet another piece of evidence.

Posted by: Hedge Fund Guy at December 24, 2004 07:16 PM

"Inflation is not in the cards in the US."

But then how will Rummy and Bush pay for their war?

Posted by: Randolph Fritz at December 25, 2004 09:26 AM

26 december 2004


breaking news. a daring daylight robbery in downtown tokyo is set to break all records for global crimes of this nature. a small cabal believed to be elected neo conmen arrived at high noon at the tokyo central bank, in a red taxi, which they claimed was loaded with several suitcase-sized tactical nuclear weapons.

the gang, wearing rubber masks in the likeness of top american political figures, were only on the premises for two or three minutes. shouting slogans - ' we are the superpower ' and ' down with everyone else ' and ' anyone not in the taxi in the next three minutes is a terrorist ' - the raiders left, taking with them the guts of the entire japanese national production effort of the last forty years - a crumpled handwritten i.o.u. note for 800 billion dollars.

while the heavy gold bars in the bank's vaults remained untouched, a search is now underway for the note. . .

tokyo police believe that at least one of the gang may have been a woman, possibly even of afro-american or mixed race. as the gang left the building they audaciously left a receipt. it read simply ' thanks suckers ' and was signed with the one word ' rumsfeld.' the signature was later found to be made with a type of rubber stamp commonly used for mass producing
sympathy notes to dead soldiers' mothers - and thus of little value. ( hundreds of these are still being issued. )

the authorities now await the gang's next move. the i.o.u. note is too big to cash and the fear is that the neo conmen may simply threaten to tear it up, thus plunging all of western civilisation into darkness.

of course they could also threaten to detonate their suitcase bombs - which would have much the same effect.

returning from his ' zen and the art of golf club membership ' midwinter weekend retreat, the governor of the bank of japan smiled enigmatically at the assembled press, refused to
answer promptings about ritual suicide, and went back to work in his office.

since then there have been no further developments. a large number of used ' greenbacks ' have been seen littering the streets of the financial district. environmental groups have complained. children have been advised not to pick them up.

every effort is being made to play down the crisis and to carry on business as usual. the yen rose slightly in after hours trading. the central bank is expected to open as normal on monday morning.


a small notice in english and japanese in the front window of the bank ( of a kind familiar in seedy back street geisha bars in the financial district ) says simply -

' please do not ask for credit - as a refusal may offend.'



Posted by: gillies at December 26, 2004 11:45 AM