For the last decade or so, most of the English speaking countries have been running large and generally increasing trade deficits, and therefore running up increasing foreign debt. At the same time, until recently, both real and nominal world interest rates have been falling, which has made debt more affordable. This has produced a sense of security which is about to be reality-checked.
Short-term interest rates have been rising for the last couple of years, and now long-term rates are rising as well. The US 10-year bond rate is now 5.1 per cent, and has been rising fairly fast in recent weeks. The effect is to add a rising interest bill to a large and growing trade deficit. Brad Setser does the math for the US and it isn’t pretty.
If the average rate [on private and government debt] should rise to 6% — roughly the interest rate the US paid back in 2000 — the 2008 US interest bill would reach $420b. That is more than three times the 2005 interest bill.
Unless the trade deficit starts turning around fairly sharply, this would imply a current account deficit close to 10 per cent of GDP, which no country has ever sustained (please point out exceptions in comments).
The story for Australia is broadly similar, though the picture is complicated by the effects of commodity prices, which still seem to be generally rising. As long as that continues, our trade deficit should decline. But, high commodity prices have rarely been sustained for more than a few years at a stretch.
John Quiggin 
On to your post,
Every asset bubble in history has affected its corresponding real economy. The first such effects are usually the expansion or issuance of whatever asset class is being bubbled, although as the mis-allocated credit reverberates through the economy the real distortions are amplified thus. How’s this for a historical example:
“Some areas of Oslo are still marked by the massive volume of residential construction prompted by the rise in prices. The housing market collapsed at that time. The demand for new dwellings was saturated. It was not until the mid-1980s that real house prices returned to the level in 1899.”
– Governor Svein Gjedrem 2/15/05
The extent to which the asset bubble perverts the real economy defines the extent to which the impact of the bubble on the economy is sustained. To believe your denialism, one would have to doubt the raison d’ etre for the financial system in general. When I went to school, financial intermediation and the capital markets were meant to allocate capital to where it can best be put to use. Not sure what you heard. In any case, if you allow the former, you cannot ignore the fact that asset bubbles distort the capital allocation mechanism and with it, the real economy (in the current case, severely- see Asia’s economic orientation).
Tell it to the Argies. There are some very fundamental principals you’re simply not getting. A currency crises means investors are significant net sellers of the currency (and denominated/related assets) to the point of ‘currency flight’. In such an instance the monetary authorities first option is to support the currency in the open market by selling reserves. However, in severe cases of currency distress, this merely puts off judgment day- it does not rectify the impetus for the currency sales. Once reserves are extinguished, only unenviable options remain: systemic collapse via the wholesale dumping of assets, (deleveraging), and concomitant high interest and default rates, or systemic collapse via hyperinflation. Pick your poison. While the latter is less dramatic in that it doesn’t require insolvencies and repossession, (less traumatic for borrowers that is), it also effectively eliminates the ability of a currency to grease the wheels of commerce, potentially for generations. In most emerging markets historically in such instances people have been able to resort to hard currency as a store of wealth. Under current circumstances, it is possible that the only real safe haven will be real non-luxury goods. In any case, the ultimate result of the currency crisis is a profound wealth transfer from savers to borrowers, and a depression.
Another thing for you to ponder Chris C: Defending a currency requires raising rates such that investors have an incentive to hold rather than dump the paper, and such that speculators cannot borrow it cheaply to sell it. If the latter’s cost of capital is cheaper than the depreciation of the currency they are selling, they can hammer a currency into the ground. Reflation by contrast requires that money is printed, interest rates lowered. Detect a contradiction? If not, you should see the Bank of England’s attempts to stay in the ERM 15 some odd years ago. That defense didn’t have what most economists would term a ‘reflating’ effect.
This shows a basic misunderstanding of money and banking. Before I get into that, let me explain to you why the distinction is NOT important. Oz imports global savings to the tune of six some odd percent of its GDP to finance its investment and consumption. It really doesn’t matter which sector of the economy- firms, households or government- are running this deficit because the Australian economy is nourished by the full complement. If the capital necessary to support the deficit is cut off, the economy must adjust by ratcheting back on demand which creates systemic stress (bad loans, deleveraging asset bubbles and teh like). Due to the extreme nature of the Australian and Kiwi CAD’s and NIIP the adjustment could be severe.
As regards your second point, credit taken on by your neighbor accrues to you. This is because it supports economic activity/demand in your community and ultimately spills over into whatever sector of the economy you make your living in. By the same token, when your neighbor stops spending and starts saving to dig himself out of debt, you might find your business takes a turn for the worse, (also btw, the same concept holds internationally). So- whether you like it or not- in good times, and in bad our lot is inextricably linked.
Ernestine,
I’ve only just noticed this line in your post.
And what a shame that is- your responses to date have been so informative.
Let’s rehash: in my original response to you I stated that monetary authorities can target individual asset bubbles by regulating the credit apparatus that sustain them- in a manner of speaking. I furthermore alluded to the fact that, beyond targeted measures, the effect of a general tightening of lending conditions, even at the margin, falls most heavily on the areas of intense speculation. In the subsequent post, I highlighted the fact that asset bubbles, (i.e. asset inflation), are dependent upon credit creation, without which the bubble cannot be sustained. Why is this not sufficient I wonder?
Perhaps you are not reconciled to the fact that the cost of the credit that props up asset prices has an inflation expectation component and that, as a result, an asset bubble cannot exist unless its yield is a good deal higher than consumer price inflation, (elementary indeed). In other words, the existence of an asset bubble alone is sufficient to imply that the, (targetable), credit creation supporting it has a larger effect on asset prices than consumer ones. Does that close the loop for you? If not this, perhaps I could trouble you for an explanation as an alternative to standoffish arrogance.
Majorajam says: “…monetary authorities can target individual asset bubbles by regulating the credit apparatus that sustain them…” I agree, but there is real money involved as well. I alluded to the Future Fund above. Let’s also not forget the 50% capital gains tax reduction brought in by the Howard govt. in (I think) 2000.
Majorajam,
Its the third time you are tryng to play the player rather than the ball.
May I suggest that an alternative assumption to that you make is that while it seems obvious that various contributors have different mental models in their mind when writing, it is not clear how much is due to different usage of terminology and how much is due to different models, and how much is due to different empirical information and how much is due to political views. This is both interesting and frustrating, possibly for everybody. On many ocasions it leads to mis-communications. There is a point where quoting and arguing leads to only more quoting and more words. When I am interested in a topic and I feel there is too much miscommunicatio, I try to put what I see as the crux of the matter in the form of one or several questions, which I can relate to the topic of the thread.
Please read:
The topic of this thread.
Your original comment.
My original comment to Chris C. regarding your point.
Andrew Reynold’s description of the Australian regulatory environment.
You seem to leave out wages (prices and quantities) in your last post. These matter (personal default, loss of employment in case of corporate default).
I assume you agree that the dynamics depend on parameter values.
If you know a simulation study which models the dynamics of the entire world economy and its complex structure (trade, financial, regulatory), I’d be most grateful getting a reference.
Ernestine,
If you present a cogent rationale for why wages are relevant to the point I made in that post, I’ll address them. As stated, it’s an unnecessary and confusing digression/non sequitur. As I said to you, the cost of capital contains an consumer price inflation expectation (short of nominal interest rate cap regulations such as those of the 1970s US banking system). This itself contains wage inflation (although the relationship is indirect/non-linear). Why bring up the minutia of the drivers of consumer price inflation when it is unnecessary to talk about the central point, which is the capacity of monetary policy to affect consumer price and asset inflations differently?
And by the way, it is you who is manifestly recalcitrant, refusing to acknowledge any of my arguments and hence, “playing the player”, (note, by contrast, my consistently comprehensive citing of people’s responses, with counter-arguments that attempt to address points as intended). In my last post, I wrote: “In other words, the existence of an asset bubble alone is sufficient to imply that the, (targetable), credit creation supporting it has a larger effect on asset prices than consumer ones.” I imagine if we took a vote, a vast majority of posters would agree that this comment speaks to your now oft repeated question:
Yet you completely ignore that and write a very abstract and verbose accusatory response. Sorry, but your shenanigans are transparent and a trifle pathetic at that. Next time you try to sneak in the last word, I believe I’ll give it to you.
Majorajam, I suggest you go to a later thread. You might learn something.
A rather interesting thread. Ernestine, her warring partner Majorjam, Chris, Terje, Katz and others have provided a most enlightening discussion. Thank you. I’m probably missing something here but the question is as follows.
There main focus in reducing CAD for those that see it as a problem is to have the monetary regulators constrain demand or have government agencies regulate it. ( for the record, I tend to think that it can’t go on forever and the consenting adults theory is too simplistic ) What could possibly be wrong with governments via policy directive use whatever political sway or will at their disposal to grow exports over the long term. Surely if exports earned what is spent on imports then CAD would be zero. I believe that we should be looking to selling more stuff rather than just buying less.
Crocodile, if you intend to ‘bite me’ by means of accusing me of introducing technicalities, then consider my comment automatically withdrawn. (Lets see how this works.)
CAD usually stands for Current Account Deficit. This includes the Trade Account (Exports and Imports) and net interest and dividend transfers.
Both, exports and imports involve quantities and relative prices (exchange rates).
I don’t wish to go beyond this ‘technicality’.
Crocodile, please replace the sentence “Both, exports and imports involve quantities and relative prices (exchange rates)” with the sentence:
Both, exports and imports involves quantities and prices. The relevant prices are local prices, transport costs and exchange rates
Out of interest is there a comparable concept to CAD that applies to trade between the states of Australia. If so does anybody know how these have evolved over time.
I think it would be interesting to discuss how this process happens within a currency zone as opposed to how it happens between currency zones.
I suppose the EURO zone might be another good example to explore.
As I see it if QLD has a trade surplus with NSW then Australian currency will tend to flow north. This should inflate assets and wages in QLD and deflate them in NSW and over time adjust the relative advantages of each region such that trade comes back into balance. Such an adjustment process is reasonably workable so long as there is a reasonable amount of price flexibility within the respective state economies.
Between areas with fixed exchange rates (or a common currency) this process of relative price inflation and deflation would seem to be a major relief valve. (although China versus USA might make for an interesting discussion on this point)
However between areas with different monetary policies the assumptions of the monetary systems will potentially push the adjustment process forward or backward in time and make it gentle or abrupt.
A common “global unit of account” would be more gentle in the adjustment process (IMHO) and as such it may reduce economic shocks. However in doing so it may cause regional inflations and deflations as adjustments become necessary. The notion that these adjustments are better made through exchange rate shifts assumes that the economic outputs of a region are highly synchronised and that domestic price movements are inhibited by institutional factors. Strangely we currently manage to tolerate such relative price movements within a nation.
“As I see it if QLD has a trade surplus with NSW then Australian currency will tend to flow north. This should inflate assets and wages in QLD and deflate them in NSW and over time adjust the relative advantages of each region such that trade comes back into balance.”
Not necessarily. The hypothetical QLD trade surplus with NSW shows up in profits. These may be owned by companies (or individuals) located in NSW or in QLD. Furthermore, all of the profits may be invested with Westpoint who dig holes in the ground in Sydney and then go bankrupt. (The foregoing contains a few simplifictions but I don’t believe they destroy the argument).
Ernestine, no bite was intended. I actually think that the technicalities have intensified the debate and amateurs like me listening on the sidelines are all the better for it. The thank you was meant with a degree of gratefulness. If yourself or Majorjam take any offence at the description “warring” then I apologise.
Reading through the many entries in the thread I had stumbled accross an explanation that asset price bubbles are inderectly linked to high CAD and hence hence the credit creation. If this is true my question was simply that could the asset bubble be pricked by the growth of exports rather than by putting the squeeze on the money supply via the RBA in an attempt to rein in imports.
Ernestine,
I think your qualification is accurate however I am not sure if it is overly significant. Especially if a high proportion of the profits are in small businesses which tend to be located near to their owners. What are your thoughts?
Regards,
Terje.
What would be the CAD of a retirement village? High I would expect.
crocodile Says:
The devil is in the detail, croc. “What could possibly be wrong with governments via policy directive use whatever political sway or will at their disposal to grow exports over the long term.”
There are a couple of easy ways that governments can try to grow exports:
– Exchange rate control, e.g. China over the past few years.
– Subsidising exporters, e.g. just about everyone.
Both of these have been well tried, and they actually do work, within limits. The problem, of course, is recognising when a limit has been reached where the policy becomes counter productive.
What a mess. Try again:
crocodile Says:
The devil is in the detail, croc.
There are a couple of easy ways that governments can try to grow exports:
– Exchange rate control, e.g. China over the past few years.
– Subsidising exporters, e.g. just about everyone.
Both of these have been well tried, and they actually do work, within limits. The problem, of course, is recognising when a limit has been reached where the policy becomes counter productive.
So if your question is “can governments prick the asset bubble by promoting exports”, the answer is a tentative “yes”, but the answer’s not really clear. There’s a risk that the government will stuff it up by not actually increasing exports, or by shifting the bubble to export industries.
SJ,
My position is that the government stuffing it up is a virtual certainty. The chances that they do the right thing, at the right time, in the right measure and then stop are the right time is so low as to not be even remotely credible.
I might not be so broad, but basically I don’t disagree.
The big risk is not knowing when to stop. Japan, for example, was the export success story of the century for a while, but it’s neo-mercantilism ended up (is still ending up) costing it big time in the longer run.
A bit of further explanation for crocodile:
The exchange rate control that China (and Japan) are doing is not something that Oz can or would want to do at the moment. They’re pissing away the value of their exports by holding the value of their currencies down.
If we want to increase exports via exchange rates, we want our currency to fall. The way to do this is by what the country is actually doing: running a current account deficit.
Weird, huh?
Our government seems to be quite mercantilism in its views on budget surpluses.
Crocodile, thanks for the comment. With the benefit of hindsight I realise I missed the opportunity of referring the warrior to Crocodile’s first post. Your point on international trade was pretty much lost.
I am a bit busy at present. I’ll reply tomorrow.
P.S.
croc: It’s probably best to ignore Ernestine altogether. He (or she) seems to be completely nuts.
Terje says:
Way not to make any sense altogether, Terje. Still, I guess you could always go and edit Wikipedia to define “mercantilism” as something to do with budget surpluses, and add that the adjectival form used to be “mercantilist, but that now for the convenience of people who don’t know any better, there’s no difference between the noun and the adjectival form.
SJ,
Lighten up, it was just word play.
Regards,
Terje.
P.S. I don’t think insulting Ernestine is terribly productive.
Mr/Ms SJ,
Cut out your silly attempts to play smart by being rude.
Be useful and correct your advice to Crocodile, which read: “If we want to increase exports via exchange rates, we want our currency to fall. The way to do this is by what the country is actually doing: running a current account deficit.
Weird, huh?”
Surely, even in Econ101 you would learnt that the exchange rate in a system we have now is not only determined by exports and imports but also by capital flows.
Since the Federal Government in Australia is not a net borrower, these capital flows are governed by the private sector.
And, incidentally, people who don’t study Economics at all can figure this one out too.
Terje,
“I think your qualification is accurate however I am not sure if it is overly significant. Especially if a high proportion of the profits are in small businesses which tend to be located near to their owners. What are your thoughts?”
This is going away from the topic of this thread. However, a few words briefly. If you impose enough additional assumptions on the hypothetical case you started off with then you may end up with a local economy (autarky). It is possible to construct a hypothetical case which results in your conclusion. However, I would consider it a ‘special case’ from which no general conclusions can be drawn.
PS: I bother replying because I believe one only understands material which one works through oneself. This is a side reference on the topic on education we had some time ago.
Ernestine,
Thanks for your comments. I agree that assumptions can be multiple and the real world is complex. I suppose I bring up the issue of interstate trade because it is analogous to international trade except with the complexity of exchange rates removed. As such it reduces the number of factors we need to make assumptions about and can provide some clarity of insight before exploring the more complex case.
My question about the CAD of a retirement village was similarily inclined. I would expect a town or village full of retired people to have a high CAD. What does this lead us to expect in an aging nation where people hold lots of overseas investments?
Regards,
Terje.
P.S. I agree that education necessitates thinking and doing as opposed to just watching and memorising.
Majorajam,
Now that you have elucidated your arguments a little more, I must say I think we fundamentally agree on one point.
‘External balance’ under a floating exchange rate regime is not of itself an issue. It is only an issue in as far as it affects domestic borrowing, interest rates and economic activity.
Would you agree with this?
On your other points:
“Every asset bubble in history has affected its corresponding real economy. The first such effects are usually the expansion or issuance of whatever asset class is being bubbled, although as the mis-allocated credit reverberates through the economy the real distortions are amplified thus.
The extent to which the asset bubble perverts the real economy defines the extent to which the impact of the bubble on the economy is sustained. ”
I never said there were no real impacts, I said:
Asset bubbles do NOT need to have SUSTAINED impacts on the real economy.
and that:
Sufficient liquidity CAN ALWAYS be created to obviate the potential aftereffects of an asset bubble.”
What I am saying is that if an asset bubble crashes and begins the process that MAY lead to all those other deleterious effects we have discussed, the central bank can prevent a full-on depression by flooding the system with liquidity.
The fact that central banks have not done this on every occassion, or been particularly successful does not negate this point.
You also say:
“Tell it to the Argies. There are some very fundamental principals you’re simply not getting. A currency crises means investors are significant net sellers of the currency (and denominated/related assets) to the point of ‘currency flight’. In such an instance the monetary authorities first option is to support the currency in the open market by selling reserves. However, in severe cases of currency distress, this merely puts off judgment day- it does not rectify the impetus for the currency sales. Once reserves are extinguished, only unenviable options remain: systemic collapse via the wholesale dumping of assets, (deleveraging), and concomitant high interest and default rates, or systemic collapse via hyperinflation. Pick your poison. While the latter is less dramatic in that it doesn’t require insolvencies and repossession, (less traumatic for borrowers that is), it also effectively eliminates the ability of a currency to grease the wheels of commerce, potentially for generations. In most emerging markets historically in such instances people have been able to resort to hard currency as a store of wealth. Under current circumstances, it is possible that the only real safe haven will be real non-luxury goods. In any case, the ultimate result of the currency crisis is a profound wealth transfer from savers to borrowers, and a depression.
Another thing for you to ponder Chris C: Defending a currency requires raising rates such that investors have an incentive to hold rather than dump the paper, and such that speculators cannot borrow it cheaply to sell it. If the latter’s cost of capital is cheaper than the depreciation of the currency they are selling, they can hammer a currency into the ground. Reflation by contrast requires that money is printed, interest rates lowered. Detect a contradiction? If not, you should see the Bank of England’s attempts to stay in the ERM 15 some odd years ago. That defense didn’t have what most economists would term a ‘reflating’ effect.”
Are you talking about a fixed exchange rate regime? If so, I agree with you – such regimes are susceptible to all the scenarios you paint, but these are inapplicable to a floating regime. There is no need to ‘defend’ the currency if you have floated it.
And you also say:
“This shows a basic misunderstanding of money and banking. Before I get into that, let me explain to you why the distinction is NOT important. Oz imports global savings to the tune of six some odd percent of its GDP to finance its investment and consumption. It really doesn’t matter which sector of the economy- firms, households or government- are running this deficit because the Australian economy is nourished by the full complement. If the capital necessary to support the deficit is cut off, the economy must adjust by ratcheting back on demand which creates systemic stress (bad loans, deleveraging asset bubbles and teh like). Due to the extreme nature of the Australian and Kiwi CAD’s and NIIP the adjustment could be severe.
As regards your second point, credit taken on by your neighbor accrues to you. This is because it supports economic activity/demand in your community and ultimately spills over into whatever sector of the economy you make your living in. By the same token, when your neighbor stops spending and starts saving to dig himself out of debt, you might find your business takes a turn for the worse, (also btw, the same concept holds internationally). So- whether you like it or not- in good times, and in bad our lot is inextricably linked.”
I agree entirely (except for the fact that I have misunderstood!). I accept that other peoples’ decisions to borrow, save and invest have an impact on the economy I operate in, and that it can impact my interest rates, welfare etc. I just reject the viewpoint that cross-border transactions should be treated as some special case.
SJ, Thanks for your comments. I understand that falling exchange rates can reduce CAD or even turn it around to a surplus. This is what appears to have happened earlier in the new century with some help from the olympic games as well. I agree that China is holding their currency purposely low to help their exporters but I don’t have the expertise to predict what will happen down the track since their peg to the US dollar is also a peg to a currency that seems unstable recently. I wasn’t really looking to direct government intervention for the reasons you and Andrew correctly pointed out. I’m looking more towards the use of government policy to encourage business to go after export markets. I am thinking of perhaps improved tax breaks for R & D projects and making life a little easier for startup organisations in acquiring plant and equipment etc. I realise this is more long term.
Terje,
Indeed, they will have a high CAD, but a significantly positive NIIP (or across provincial borders, high NIP). Provided their actuarial assumptions are correct and they stick to their fixed budgets, they should also be just fine.
Crocodile,
I hope you don’t mind me capitalizing your moniker. About your question, the relationship is rather that asset bubbles and CAD’s are a match made in heaven because CAD’s are engines of credit creation, and because credit creation is the fuel of asset bubbles which themselves stoke demand. It’s a quite potent positive feedback loop. Your question is a very reasonable one and the suggestion is one trumpeted that’s been trumpeted loudly by the U.S. Treasury amongst others. The best case scenario is actually both a pick-up of export growth and a slow-down of import growth, although this is a pretty fine line to walk. Should export growth pick up with-out such a substitution effect, you would have unsustainable demand growth and a break-out of consumer price inflation (which would eventually cause demand to collapse via policy restriction from central banks or the deleterious effects of rampant consumer price inflation).
Here’s the rub: there is really only one mechanism by which this type of substitution can happen- a weakening exchange rate. The only trouble is, the countries whose currency appreciation would do the most to facilitate the substitution, won’t let their currencies appreciate. This leaves unilateral slowing of demand and protectionism as the only two potential policy options, both having their drawbacks. Nevertheless, the drawbacks are nothing compared to those of a full-blown currency crisis, which means to date, policy makers have chosen poorly. In any case, I fear that we have passed the point of no return for any policy move to avert the inevitable.
PS SJ provides sage advice. I only wish I’d heard it a few posts ago.
NIIP (net international investment position) measures the value of overseas investments. It does not measure the income from those investments. I would think that both are important, whilst for a sustained CAD the income component is the most significant.
In the example of a retirement village where the people live forever then they can run a CAD forever so long as their investments continue to deliver sufficient income. If they grow old and die then they can wittle back their investments and eat the equity.
Given Australias superannuation funds are investing abroad then any concerns about our CAD should include a discussion of these other factors. Are we borrowing from abroad in order to run a CAD or are we repatriating profits from abroad in order to run a CAD. It makes a big difference in terms of sustainability.
I don’t have hard data but my guess is that Australia is in better shape than the USA.
Terje,
Current account deficits incorporate an investment income component. Apart from some nuance regarding valuation, the NIIP is indeed simply a running sum of CADs.
Australia’s NIIP is actually a larger percentage of its GDP than is America’s for the moment. There are reasons why it is less worrisome however- mostly this has to do with the level of the trade deficit, (in particular as a percentage of exports), and the “exorbitant privilege” the US has enjoyed since WWII (i.e. the return advantages of being a reserve currency). In other words, the US has grown accustomed to that return advantage and faces a rude awakening if, (and more to the point, when) the world finally gives up on the dollar.
Gold touched US$710. A 25 year high. The Federal reserve needs to be moving fast to mop up excess US dollars. They have let commodity prices get out of hand (again).
Looking at the ten year gold chart the US descent into deflation in the late 1990s is clear. The current ascent into inflation is stark.
Ten year gold price (US$):-
http://www.kitco.com/charts/popup/au3650nyb.html