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January 17, 2005

Brad Setser Grades Tim Geithner

He gives the speech of his ex-boss the kind of close-reading treatment that I usually only give my graduate students' qualifying exams:

Brad Setser's Web Log: FRBNY President Tim Geithner's latest speech ...: Today, perhaps the biggest risk out there -- as Geithner notes -- is the risk that the market moves required to correct major macroeconomic imbalances (i.e. the US current account deficit) may be large and abrupt, not small and undisruptive.

In the financial markets, this broadly positive outlook has been accompanied by a dramatic reduction in risk premia, leaving the price of insurance unusually low against a less favorable or more volatile environment. These developments imply a view among market participants that future macroeconomic shocks will be more moderate than in the past and more likely to be absorbed without broader damage to economic performance or the financial system ... they imply that the imbalances in the global economy will be diffused smoothly

A bit further along Geithner notes:

This combination of fiscal sustainability problems, large external imbalances, and the tension in the existing exchange rate system creates the risk of unanticipated shocks to financial prices, even in a context where monetary policy credibility is strong. The probability of these shocks may be low, but it is higher than it has been, and higher than we should be comfortable with.

Like Delong, I would put more emphasis on “higher than we should be comfortable with” than on “may be low.” What steps does Geithner suggest to protect ourselves against this set of risks?

1) Take advantage of the "unusually low price" of insurance. After all, low prices can reflect an absence of sufficient demand for insurance. Consider one example: the US Treasury. It could insure against a rollover crisis -- or against the more probable risk of significantly higher short-term interest rates -- by lengthening the average maturity of its new Treasury issuance. 4.2% nominal for ten years is not bad! But issuing ten year Treasury notes rather than two year or five year Treasury notes means slightly higher current borrowing costs. It also runs against the current de facto policy of keeping the supply of ten year notes tight to help keep the 10 year rate low ... See this Roubini post for all the gory details of recent US debt management.

Or consider the use of interest rate swaps by corporations who issue long-term fixed rate debt and then swap their long-term debt into short-term floating rate debt to save a bit of money -- and old Bill Gross concern relayed by the Capital Wire. This may note be as prevalent today: "curve flattening" (the reduced gap between short-term and long-term rates) should be making this kind of trade less attractive. But no doubt there are other examples out there.

2) Borrow less. Geithner warns: "the present fiscal trajectory entails an uncomfortable scale of borrowing and little insurance against possible adverse outcomes in an uncertain world." I presume the reference to Rubin's In an Uncertain World will not be lost on many in the Bush Administration, nor will the implicit call for a Rubinesque policy of limiting US borrowing in good times, to better prepare for bad times. No disagreement here. The US is on track -- using realistic assumptions -- to run ongoing fiscal deficits of around 3.5% of GDP even with steady, sustained growth, and thus has no fiscal "buffer" against worse than expected outcomes: an interest rate shock that increases the government's borrowing cost, a recession that reduces tax revenues, a more expensive than expected war ...

One small point of disagreement. Geithner -- like most -- recognizes that current account deficits of 5-6% of GDP cannot be sustained indefinitely: the real debate right now is over how long those deficits can be sustained. Geithner, though, argues the flexibility of the US economy may allow a relatively painless adjustment (a Greenspan theme). I am a bit less sanguine. The US has a fair bit of experience shifting resources (capital, labor) out of the production of tradable goods; much less experience shifting resources back into the production of tradable goods. Yet it is pretty clear that at some point, the US either has to export more, or it will have to import less -- and the required change is large in relation to the United States small export base (a key point made by Rogoff and Obstfeld, among others)

But even if labor can be redeployed quickly and easily into “tradables” production (Some people who left Ohio for Florida might need to move back!), there are limits to how fast the United States' capital stock can change. Consider how our existing capital stock constrains our ability to adjust to a different kind of shock – an oil shock. To paraphrase Rummy, when an oil price shock hits, you are stuck with the car you have, not the car you might want to have. Even if you want to dump your H2 in the used car market and buy a Smart car, someone else has to buy the H2. The auto fleet turns over, but not overnight. Even if all new car buyers opt for itsy bitsy fuel-efficient cars, there will be lots of SUVs in the American fleer for some time.

Similarly, when the US finds it has to reduce its imports to match its exports, grow its exports to match its imports, or do some combination of the two, it will do so with the capital stock that is being created by investment decisions being made today. The US will go into an external adjustment with its current export sector, not the export sector it might want to have. My worry? I don't think there is much evidence that current low interest rates are spurring a wave of investment in US export industries, or in industries that compete with imports (deciding not to offshore something already done onshore doesn't help to reduce the US import bill ... activities now done offshore need to be moved onshore).

Over the next five years, if you want a really big commercial airplane you won't be able to by one from an American manufacturer. Or, more accurately, the American product will be somewhat smaller and based on a 1960s era design (admittedly, a great design, and one that has been updated several times). While Airbus is creating a brand new production line to expand its product range, Boeing is shutting down several of its older aircraft production lines, and the new line for the 7E7 is still some ways off.

Boeing-Airbus is just one example, and probably not the most typical, since Asia is not (yet?) a player in the commercial aircraft market. More generally, though, the current pattern of investment is, in part, a byproduct of the distortions created by the Bretton Woods two system of central bank financing for US deficits. The implicit interest rate subsidy from Asian central banks spurs interest sensitive sectors, but Asia's undervalued exchange rates discourages investment in sectors that currently compete with Asia, or will do so in the future. The result: plenty of investment in hard-to-export residential housing ...

Posted by DeLong at January 17, 2005 01:37 PM

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Tracked on January 19, 2005 12:39 PM


>>These developments imply a view among market participants that future macroeconomic shocks will be more moderate than in the past and more likely to be absorbed without broader damage to economic performance or the financial system <

oooooohhh, scary. Notoriously, premium cycles do not reflect optimism about the underwriting environment. Anyone with passing familiarity with the insurance market (check out a few of Warren Buffet's remarks) would say that it is more likely that premium cycles reflect a whole lot of loose money piling up with no corresponding opportunities to invest it productively in real capital assets.

Posted by: dsquared at January 17, 2005 01:45 PM

This seems to be saying that someday, probably soon, people overseas are going to start realizing that we don't have the money to pay for the stuff we have been buying from them. Then they will stop taking our IOU's, and even our actual cash money will be worth less to them because they think we might go bust, and we don't have anything they want to buy anyway.

Then we will have to start making our own stuff, but its going to be hard becase we have laid everybody off and torn down the factories. Where will we get the money to build them back again? Wait and see, 'cause nobody knows.

But, hell, I don't even know what "marginal" means.

Posted by: pragmatic_realist at January 17, 2005 05:29 PM

Not only have the current low interest rates not spurred investment in any industries meaningful to our trade balance but neither have the much touted "job producing" tax cuts. What a surprise.

Posted by: Jim S at January 17, 2005 05:54 PM

On shifting to tradables. What ordinary people (including writers for the WSJ) don't seem to understand is that the shift requires a shift away from Consumables. There may be some give on investment if interest rates get high enough, but the heavy lifting to get the deficit under control is a cut in consumption. This is going to be hard to do, unless households and their putatitive agent, the government, have a big change of heart. We haven't seen much of that.

This is a hard-crash scenario. The only plausible way of cutting consumption is a crash in income.

Posted by: Knut Wicksell at January 17, 2005 06:49 PM

Another remarkable post, and most discouraging.

Ah, we are a service economy. Don't you wish you were a service economy? So has gone the refrain for years. But, now we must consider that exporting Citigroup or Avon to China means investment and lots of employment in China but not much in the way of "exports." There are earnings to the companies, but where are the exports? Then even though the dollar declines more against the Yen or Rupee, or declines at all against the Yuan, the effect on American exports will be limited. Imports then must fall to get to a better trade balance, and that means significant price increases for imported goods.

Posted by: anne at January 17, 2005 07:01 PM

Warning: non-economist posting here. So my "theory" is crackpot material, suitable for the circular file, I know.

Fine, tell me so and I promise to shut up.

Here's my question: Isn't the U.S. acting as the guarantor of global oil purchasability in dollars, in return for other countries' continuing willingness to buy and hold our debt?

This would follow logically on the pre-1970 era in which the U.S. was the first and, at that time, historically largest producer and exporter of oil. The system continued to function pretty much as before, sans gold of course, but with the U.S. now bringing other countries' oil to market instead of their own.

Isn't it true that the guaranteed availability of oil now dwarfs in importance any minor questions about which way the "capital" (another obsolete term) is flowing?

Remember, just tell me I'm completely full of shinola and I promise never to ask another dumb question here. But I really would appreciate hearing some kind of response to my crazy idea.

Posted by: Ralph at January 17, 2005 09:16 PM

Adding homilies onto homilies, the American economy is like an inflatable boat, an old and abused inflatable boat that the Fed has to keep pumping and pumping. Sure the tubes still look OK, and we can scoot around pretty fast even, but one of these days Fed won't be able to pump fast enough, and we won't be able to zoom to dry land quickly enough, and our inflatable economy will fold in the middle and sink like Titanic.
By way of visual image. Clearly, in America's money-class based society, some would have H2 lifeboats and some would become mere QQ flotsam. Have you seen the Airbus A380 yet? Have you seen the GMC drive-by-wire prototype yet?

Posted by: lash marks at January 17, 2005 10:44 PM

I have been scouring everything I can read about predicitions for the immediate future of US economy. What is slightly amazing to me is that here is can say. You would think, like weather, people would have a more or less handle on this.

The problem as I see it is you have a very complex, sort of mathematical, system with a large amount of imputs, plus a huge element of human psychology. And I think that human psychology trumps math up until the very end.

So, to accurately predict you have to use non-rational means. You have to feel coming wave, like chickens and earthquakes. This requires a clear mind and large powers of concentraition. What do you all feel?

I feel deepset, widespread global pesimmism. How does that figure into the math?


Posted by: cw at January 17, 2005 11:16 PM


I worked at Boeing. There is very little differenc between their planes and Airbus.The idea that there is any innovations at airbus that Boeing dosen't know about and can't add to their airplanes is ludicris. What has handicapped Boeing is 1.an antiquated production process, 2. bad managment, 3. airbus' huge governmental subsidy.

That said, airbus has made a huge bet on the super jumbo, boeing has dithered and made a cowards bet on the dreamthinger. With Airbus's structural advantages, they will probably come out ahead no matter what, but it will be intersting to see if the can get their money back on the superjumbo, though that may not be the main objective.

Posted by: cw at January 17, 2005 11:22 PM

To paraphrase your paraphrase of D. Rumsfeld, domestic real estate prices are not based on what we have in future stock, but what we have to choose from now. Therefore, to paraphrase Greenspan, while it may not be incrementally more expensive to build a future house out say, one or two years into the future, nevertheless, the housing market prices in an increase to hedge. A big one. People sell at the moment they buy, trading one mortgage for another, and the pressure of that exchange, plus egregious 10% realtor + mortgage fees and 3-5 year turnover, practically guarantee a runaway housing market.

Similarly, while commercial office space can certainly be built cheaper than the lease rates it's going for now, in say two to three years, nevertheless, occupancy is so marginal nobody can get both permits, land *and* financing, so lease rates will continue to rise ... short-term and long-term both, until the economy picks up.

But with China-India capping any economic growth in manufacturing or tele-service industries, and the Fed/States tapped out, there can be no real job growth beyond mere replacement, therefore no long-term investment, pushing the attraction of new job creation further overseas, and running up the price of commodities that China-India are consuming like a black hole, while holding the price of domestic labor at a standstill.

That's a catch-point scenario, where the curves will slide slowly towards their dynamic point of equilibrium, then with high commodities plus real estate but no real growth, in employment or in wages, (and hamburgers going for 25c again), the whole s--tcan will suddenly flip inverted, and go down like Alaska 261.

Will it be US, or China-India who flips first?
Remember 1973? Wait 'til all the Iraqi veterans start coming home looking for re-employment!

Of course, it's all relative to whether people borrow on their credit card, or merely use it as a cash-free convenience. At 28%(!) interest and penalties for an unpaid credit balance now, you don't want to be caught on the deficit side when the ship of industry goes inverted, while if you have a 401(k) liferaft, you couldn't care less.

The monied class feeds off the employed class, while the ones in between keep trying to pay down their credit balance. ROI for the banks is a 3-year rollover at 28% interest and penalties, forever. With an "F". Permanent wage slavery.

Look for lots of abandoned low-end housing and lots of beat used vehicles crowding the market, with lots of "will work for food" folks crowding the freeway on-ramps and choking hospital wards.

Look for Uncle Ernie and his wife Maude to ask if they can stay with you for awhile until they get on their feet. Look for a boom in auctioneer jobs, foreclosure, debt collectors and repo men.
Look for cigarettes, alcohol and check-cashing,
cheaper, and cheaper, and cheaper imported crap.

Look for the incredibly sad stories of Skid Row.
A thousand points of light ... all winking out.

Or ... not! Anything can happen at anytime. One thing we do know, we will never see 25c a gallon gasoline or a pack of cigarettes again. Right?

Posted by: Tante Aime at January 17, 2005 11:25 PM

Whew, that rant from Tante was enough. Let's get that breadline forming.

First there is no end to the work that can be done. New employment would have to come from new demand. What on the American economic landscape looks like a source of new demand and a source for new employment? I don't want to be the first labeled a pessimist, but I can't see anything.

However, if there is something new to make or a service to perform, do we in the States have the skills to do it for an employable price? There's a lot of technical studying going on in India or China where young engineers are ready to work at some fraction of the U. S. wage. Plus with all the making of stuff being done over there, the skill set is building up there while atrophying at home. It's possible that new business ideas are thought up, but except for the boss, the head salesman, the boss' assistant and a couple of other positions, the rest of the work gets sent overseas. Where will the new stimulus in the U. S. come from?

The preliminary design and engineering for those new beautiful Apple products is done in the U. S., but a lot of the other work is done in China, Taiwan, Korea. Some of the good profit margin parts probably still come from Japan. If there are U. S. designed chips in the pieces they are probably made in a Taiwan owned chip fab.

Anyways, my metaphor is we're going the Niagra in a barrel but some of us at the top will survive. Good luck.

Posted by: Chris at January 18, 2005 02:04 AM

And I second that comment from Jim S that low interest rates haven't induced investment in the States (it has helped over investment in China to make consumer goods), and that the Kudlowian tax cuts haven't helped induce investment in the U. S. that leads to employment to make stuff.

We (Americans) are all too optimistic about how our capitalism society will provide. I have heard that theory that we think and collect royaltyies while others sweat and earn wages. Who's to say the next good ideas won't be thought up by someone living in a foreign country? All pretty basic ideas anyways.

A lot of us will just believe crap. Look at Kudlow's continued presence on the national media landscape.

Posted by: chris at January 18, 2005 02:15 AM

Tante, I can assure you that there will not be thousands of homeless crowding the hospital wards today. That system died years ago. Most hospitals won't even consider admitting anyone who can't pay at least something if their condition isn't immediately life threatening. In many states even the public hospitals sold out and closed down, agreeing to some form of subsidizing indigent care with the survivor private hospitals. Of course, the private hospitals take the state's money and then dump the patients, but that's another matter.

Most hospitals are operating close to life support themselves these days and Dubya's announced budget cuts will likely push something like another 10% to 15% into closure as soon as the budget gets approved. The remainder can't pick up the slack. The picture won't be pretty. You have been watching The History Channel's "History of the French Revolution" though. The juggernaut draws near.

Posted by: PrahaPartizan at January 18, 2005 03:23 AM

We should consider that we have had 2 years of fine stock market gains in America and internationally. Also, the American bond market has been terrific for 5 years. International bonds have been strong for 5 years, and especially so in emerging markets. The bond market is telling us inflation is not a problem. Real estate prices have risen in America and abroad for 5 years. Commodity prices have been rising. With markets this healthy, possibly the end of the world is not quite so near.

Posted by: lise at January 18, 2005 09:38 AM

lise -- Tis very true that the bond market has been terrific for the past five years. So has the real estate market. Calling a turning point is hard. But I do think there is a real risk that these markets have peaked. the structural conditions that supported these markets -- low policy rates in the US, strong central bank demand for US dollar bonds, etc -- may not last forever.

Posted by: brad at January 18, 2005 09:59 AM

That may not be true. The US is occupying Iraq, but Iraq's oil production has not increased as a result.
Boeing vs. Airbus is a factor until the dollar drops to the point of offsetting the Airbus government subsidy. Incidentally, while Boeing the company gets US government subsidies in the form of defense contracts, Boeing the airliner manufacturer does not. So even when the dollar crashes, the treasury bonds don't sell, and the defense contracts end, Boeing will still be selling airliners.
And when the dollar crashes and America's oil prices go sky high in dollar terms and we don't use as much oil, that will leave more oil for the rest of the world to use at a lower price, triggering their purchase of a lot more (Boeing) airliners.

Posted by: walter willis at January 18, 2005 10:42 AM

The point of the A380 is, at least partly, to kill boeings golden goose (747 sales are massively profitable because the R&D and production line are paid off) and to achive customer lock-in: By having the biggest damm peoplehauler you can fit into a airport be a airbus plane, airlines that serve the major hubs pretty much have to buy at least that one type of plane from airbus, and once they are flying one kind of airbus plane the marginal logistic and training costs for all the other airbus types are much lower. Cockpit commonality - Parts supply - that sort of thing.
It's not a loss leader though, the current order book is large enough that the odds of the type loosing money are quite small.
Re: the subsidy. It's quite cunning really - we loan airbus the R&D and launch costs for a new plane type at a very reasonable interest rate and they pay us back out of profits - and since airbus has been batting 100% on new type launches so far, it hasn't cost taxpayers anything.- Much, much cheaper than the taxbreaks boeing gets.

Posted by: Thomas at January 18, 2005 10:57 AM

Willis, while I am the last one to contest that a Defense dollar is the same as a direct dollar, Boeing no doubt (and certainly the two companies I've worked for that had Defense-funded arms) still leverages the hell out of that dollar.

Start just with the bodies (the people, not the plane) themselves.

Remember how complex an airplane is to design, and maybe it's even more complex to manufacture. There's a steep learning curve for any new hires in the way everything is done. You may understand fluid dynamics perfectly, but do you know the modeling software Boeing uses? Maybe, maybe not.

So you start new hires in the Defense side and train them there. This works out great, especially considering that Uncle Sam will generously pay for their presence while they are getting the security clearance they need. This will take at least 9 months according to my SuckAtTheTaxpayersTeat friends. Mostly they read newspapers, but they do get dragged to training and the like.

As far as the oil price drop re the rest of the world, you still have to have something they want to buy. Airbus believes that China and India, as well as the US, will need a much bigger airplane to get any efficiency out of an airport at all. Remember it takes exactly the same airport resources (gate time, runway time) to launch a 200 passenger airplane as it does a 400 passenger.

Posted by: a different chris at January 18, 2005 12:38 PM

If it was just the US Europe and Japan I don't think there would be much to worry about. The trade gap would gradually shift due to autos, agriculture, and all sorts of other things made by smaller firms that I wouldn't even have thought of if I hadn't read about it.

But oil worries me. This we cannot make, so the lower the dollar goes the more we will have to trade for it (because as was pointed out, our economy will be incompatible with expensive oil).

And China presents a problem on a scale we've never dealt with before. At the rate they are improving their productivity every time they try to adjust pricing up it won't be enough.

Put them together and it is even worse. Some oil analysts like to call $50 per barrel oil expensive based on extraction costs in dollar terms, but that's only on the order of a few hours of labor to an American. To a Chinese worker that would feel more like $500 per barrel. Does anybody here agree or disagree that this aspect will lead to some sort of economic disaster, perhaps in the next few/several years? Could 2004 have been just a taste?

Posted by: snsterling at January 18, 2005 01:32 PM

Tante Aime,

Why do you think it will only be abandoned low cost housing? Isn't a lot of the predicted housing bubble in the higher-end new housing? Also, based on the people portrayed in the credit counselling commercials I see on TV, quite a few folks with decent incomes are as financially stretched as lower income folks, maybe more so. If things turn ugly, I bet there'll be a lot of abandoned houses with swimming pools as well.

Snsterling, I wouldn't look to our agricultural exports to grow (no pun intended) much to help offset our trade imbalances. If I am not mistaken, the competition in the global agricultural export market is pretty strong, and the US no longer has the dominance it had in, say the 1970s. Furthermore, US ag is extremely dependent on expensive inputs such as machinery, fuel, pesticides, herbicides, fertilizer ( all of the previously mentioned heavily dependent on oil)and expensive hybrid seeds that must be purchased every year from seed companies. If the economic situation gets as dire as some suggest, I can't see how the cost of any of those inputs can realistically be expected to decline. Our agricultural system is really imcompatible with expensive oil.

Posted by: aiontay at January 18, 2005 03:57 PM

"Tis very true that the bond market has been terrific for the past five years. So has the real estate market. Calling a turning point is hard. But I do think there is a real risk that these markets have peaked. the structural conditions that supported these markets -- low policy rates in the US, strong central bank demand for US dollar bonds, etc -- may not last forever."

Thank you, Brad.

Posted by: anne at January 18, 2005 04:49 PM

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