Wednesday, July 16, 2008

Could This Be The Tipping Point?

Amidst the headline news of failing financial institutions and stagflationary conditions in the United States, there has been one U.S. story that so far has been good news: central banks in Asia and oil-exporting countries continue to support the financing needs of the United States. According to Brad Sester, this foreign financing was $283.5 billion during the first half of 2008 and continues unabated. As is well known, this support one day will end--the United States cannot forever live beyond its means--but now would not be a good time. Most Americans do not recognize their dependence on this foreign financing nor the added stress the U.S. economy would be under in its absence. The sustained nature of this quiet bailout, as Brad Sester calls it, has been good news for the weakened U.S. economy.

Some observers, however, are now warning this financial lifeline may be in jeopardy given recent events. Ambrose Evans-Pritchard reporting on a Merrill Lynch paper writes the "US faces global funding crisis." From his article:
Merrill Lynch has warned that the United States could face a foreign "financing crisis" within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst.
The main point of the Merrill Lynch report is that the recent spate of bad economic news may be the tipping point for the end of this global financing arrangement, popularly known as Bretton Woods II (BWII). Nouriel Roubini makes similar points here. So what do you think? Is this really the end of BWII?


  1. Professor,

    A couple years ago, Ricardo Hausmann and Federico Sturzenegger wrote a paper about "dark matter", the difference in the quality of investments within the U.S. and outside the U.S. Because of this difference, the negative current account balance is essentially offset by the better quality of U.S. investments overseas (as quantified in the NIIP), and the predicted failure of BWII has not materialized. Setser essentially has argued that this is a temporary phenomenon, and I don't recall Roubini ever directly addressing the Hausmann paper although he may have. Two weeks ago, Setser remarked that the NIIP of the U.S. is improving a bit although he did not correlate the Hausmann paper into his conclusions.

    I would be interested in getting your take on Hausmann. More can be found here

  2. Another point worth mentioning...part of Roubini's solution to the Fannie/Freddie fiasco is to force the bondholder's to take a 5% haircut on their holdings of agency debt. By doing so, that may have initiated the end of BWII, since much of the agency debt is held by foreign countries. My thought here is that Paulson is choosing instead to have the taxpayers pay for the bailout thus reassuring our foreign lenders that we will continue to honor BWII.

  3. Salvatore:

    My apologies for getting back to you so late. The dark matter idea is an interesting one, but I am not convinced there are enough intangible assets out there to wipe out the global imbalances. Yes, there is some dark martter, but on the scale suggested by Hausmann and Sturzenegger? I may be wrong on this issue, but for now I remain skeptical.

    A couple of other thought U.S. investment income. First, if there is this massive amount of dark matter out there, when did it appear? When the U.S. first started running persistent CA deficits in the early 1980s? The timing of this dark matter's emergence seems to be an important issue. Second, if you look at the investment income as a percent of U.S. GDP it has been declining since the 1960s. Back then it got as high as 7.5% of GDP while more recently it has fallen to the 2-3% range. I would think that as the U.S. economy grows it would be producing and exporting the same or more amount of dark matter.

    On related note, a commentator on this blog once referenced Phelps (I believe)as arguing the U.S. saving rate is understated for similar reasons. His story was that the official national accounts were missing all the investments in human and other intangible capital that took place with the computer revolution. If his story is correct, then it too would point to a smaller if not positive CA balance (since CA = S - I).