Economic policy

The elephant in the corner

John Quiggin61 Comments

I got the conference volume from the Reserve Bank of Australia 2005 Conference quite a while ago, but I’ve only just read them. The main focus is on the decline in the volatility of the business cycle observed in the English-speaking countries since the mid-80s (or in Australia’s case since the end of the last recession).

There’s a lot of discussion of monetary policy, micro reform and so on, but no mention of what I would see as the single most important factor – the abandonment of the external balance objective. For most of the postwar period, economic policy makers juggled the desire to keep the domestic economy stable with the constraint imposed by the balance of payments. Not surprisingly, this was a difficult job and promising economic expansions were regularly choked off because of emerging current account deficits.

Now we have a deficit of 7 per cent of GDP (as do most other English-speaking countries) and no one worries. The assumption is that borrowers and lenders are consenting adults who can make their own decisions. Right or wrong, this assumption makes macroeconomic management an awful lot easier.

We may well be about to find out whether policymakers have been right to view trade deficits with benign neglect. The US dollar seems to be beginning its long-awaited depreciation against the euro and other trading partners (even against the $A) and long-term interest rates are rising. Some combination of the two should sooner or later bring the US back into trade balance. The question is whether this adjustment will be smooth or painful.

61 thoughts on “The elephant in the corner”

  1. A puzzle I have is that the RBA last week computed that if we redefine savings to include superannuation and stock market capital gains then the US and Australia have very high rates of savings.

    But I thought current account deficits were driven by deficient savings. Or am I missing something blindingly obvious.

    On the high savings being defined inclusive of capital gains, it is correct to say that the stock market has risen with firm profitability – so price/earnings ratios have not got too much out of wack. But partly the boom is driven by a huge rise in commodity prices. If these collapse and the market falls do our measured savings rates become negative? I assume so.

    Access Economics today criticise the Government for betting the commonwealth budget on a sustained commodiity boom that we know will end. If that’s true isn’t the RBA also betting that our savings rates are high assuming that the commodities boom will last forever?

  2. Harry, do you have a reference for the RBA’s argument about capital gains?

  5. This is the correct link to the document Harry Clark refers to. It’s a big .PDF file, and the relevant discussion is on page 52, not 47.

    Reproduced here for convenience:

    Box D: Capital Gains and Measures of Household Saving

    The most frequently-cited measure of household saving is the net saving rate, which is measured as a residual by subtracting consumption and depreciation from household disposable income. On this measure, the saving rate of Australian households has been declining, and in recent years has been negative (Graph D1). This is lower than in many other developed countries, though not dissimilar to developments in the US. Adding back the amount deducted for depreciation (most of which is on housing) lifts the saving rate, though the position of Australia and the US remains below average. These conventional measures of saving are calculated from the household income account in the national accounts and do not include in income (and therefore saving) that part of the return on investments that comes in the form of capital gains. In the case of equity investments, for example, only the return that is in the form of dividends is included as income even though historically this has accounted for only about one-third of the overall return on equities.1

    In countries such as Australia where the composition of household investments has shifted from bank deposits and fi xed income to equity holdings, this measure of saving has increasingly understated the true extent of household saving. In such countries a more meaningful measure of household saving is the change in household net fi nancial wealth, defi ned as household financial assets (bank deposits, bonds, equities and unit trusts) less non-housing debt. This measure, which can be directly measured using fi nancial data, focuses only on financial wealth and abstracts from wealth in the form of dwellings and the household debt used to fund that investment in dwellings. To the extent that households borrow against dwellings to buy financial assets (i.e. engage in housing equity withdrawal) the measure of financial wealth used here would be overstated, but on average over the 1990s the impact of this has not been very significant.

    Graph D2 shows net financial wealth of Australian households, per head of working-age population. It has risen from $32 000 in 1991 to $90 000 in 2005. Also shown on the graph is the increase in wealth that would be implied by the cumulation of (net) saving as measured in the national accounts. This latter series shows a much smaller increase, with the bulk of the gap between the two lines due to the compounding of capital gains on equities which, as noted, are not captured in the conventional saving rate.

    Graph D3 shows a broader measure of the saving rate calculated from household net fi nancial wealth – i.e. as the annual change in net financial wealth expressed as a proportion of household disposable income. This broader measure is more volatile than conventional measures because of year-to-year changes in equity valuations, but it is also significantly higher on average and does not exhibit the same downward trend. This measure, which is more relevant to a country where households maintain a large proportion of their wealth in equities, presents a more realistic picture of Australian household saving behaviour than conventional measures.

    It is also interesting to note that on this broader measure of the household saving rate, Australia is not out of line with international experience. Countries which have relatively high household saving rates as conventionally measured (e.g. countries in Europe) tend also to be those where household investments are mainly in bank deposits and fixed income, whereas in countries with low household saving on conventional measures (of which the US and Australia are examples) households hold a greater proportion of their investments in equities. Once the capital gains in these are included in saving measures, the international dispersion in saving rates is reduced (Table D1).

  6. Harry

    the current account deficit is equal to the excess of investment over saving, but this is the national accounts definition of saving (income minus consumption), and that definition excludes capital gains as part of income, so it isn’t part of saving either.

  7. Uncle Milton, I understand that but are they not supposed to conceptually approximate the same idea – what you don’t spend or you add to your wealth. Indeed I always thought these last two ideas were the same. Are you saying that the link between current account deficits and deficient savings apllies to the conventional definition of savings but not the other. It sounds then like then they are trying to represent different things. I am still confused. What are the respective different ideas trying to point to?

    Maybe we need to redefine the idea of a current account deficit in each situation.

  8. Personally, I find this part of Barry Eichengreen’s paper on Reserve Currency Competition more enlightening than the RBA’s speculation:

    Michael Mussa (2004), in a recent analysis, provides a simple way of thinking about this. Mussa shows that the ratio of net foreign liabilities to GDP, denoted n, stabilizes when c = n ∗ g, where c is the current account deficit as a share of GDP and g is the rate of growth of nominal income. If g is 0.05 (3 percent real growth plus two percent inflation) and c is 0.025, then the debt ratio stabilizes at 50 percent, double the current 25 percent and perhaps the plausible upper bound on how much U.S. net debt foreigners might be willing to hold. (This is also what Mussa assumes, subject to some caveats. It will be useful for what follows to assume that inflation in the rest of the world also runs at 2 percent, the upper bound of the ECB’s target range.)[41]

    Assume now that the United States does nothing to raise its public and household savings rates and that the current account deficit is allowed to continue running at 5 percent of GDP. With g = 0.05 and c = 0.05, the debt ratio now stabilizes at 100 percent.[42] This is a much higher ratio than ever incurred by a large country, much less by a reserve-currency country. It implies that foreigners would have to hold a considerably greater share of their portfolios than at present in the form of claims on the United States. This result, in other words, is implausible. Something has to give.

    One way of squaring the circle, assuming no change in c, which is what we are assuming for the moment, is to raise the rate of inflation from, say, 2 to 7 per cent, with the result that the rate of nominal income growth rises 5 to 10 percent.[43] With c = 0.05 and g = .10, n again stabilizes at 50 percent, which we are assuming to be the upper bound. The most likely way in which this would come about is that foreigners would grow unwilling to add more dollar-denominated securities to their portfolios. Keeping the share of dollar-denominated securities in foreign portfolios constant, even while the U.S. continues to pump additional treasury bonds into the world economy, requires the dollar exchange rate to fall.[44] And once it begins falling, there may be a “rush out of dollars,� as investors scramble out in order to avoid ending up holding the bag (that is, to avoid incurring large capital losses as a result of being late). And the faster the dollar drops, the greater are imported inflation and upward pressure on U.S. inflation generally. This is how market forces produce the acceleration in inflation that limits the U.S. external debt/GNP ratio to levels acceptable to investors.

  9. For clarification: in the quoted passage above, substitute Oz for U.S., and it makes sense.

  10. “For most of the postwar period, economic policy makers juggled the desire to keep the domestic economy stable with the constraint imposed by the balance of payments. Not surprisingly, this was a difficult job and promising economic expansions were regularly choked off because of emerging current account deficits.”

    Up to the mid 80s. Well, yes, but what also true of the period 1945-mid 80s (more or less)?
    Fixed or managed currency exchange rates. In order to keep to the Bretton-Woods rates (for example) such deficits had to be restrained by cooling the economy.
    With floating exchange rates (unmanaged in so far as they are indeed unmanaged) this constraint no longer applies, does it?

    Now, whether people should be paying attention or not is another matter but isn’t at least part of the answer to the difference in behaviour pre 80s and post to do with the absence of the currency rate constraint?

  11. “are they not supposed to conceptually approximate the same idea – what you don’t spend or you add to your wealth.”

    Harry,

    one definition of savings is income excluding capital gains minus consumption.

    The other definition is income including capital gains minus consumption.

    Both definitions approximate the idea – what you don’t spend out of your income. The difference is that the second one includes changes to income from changes in asset prices, so it probably is a better measure of changes to wealth.

    “Are you saying that the link between current account deficits and deficient savings apllies to the conventional definition of savings but not the other.”

    I haven’t thought about it deeply, but I reckon it does. But I’m not sure. If you think of a capital gain as the net present value of future changes to income, then the second definition of savings (minus investment) might be related to the current account in that it represents the net present value of future current acconts balances.

  12. There’s actually two quite distinct issues in realtion to ‘holding gains’.

    The first concerns equity price rises that simply result from firms’ reinvesting rather than paying dividends. It’s reasonable that households should think of this as income and saving (it’s certainly taxed on that basis). On the other hand, from the point of view of national saving, it doesn’t matter whether it’s counted as household or enterprise income and saving. The question is, if we’ve identified households as the irresponsible sector running up excessive debt, does this let them off the hook? I agree with Harry that John needs to comment on this.

    The second issue concerns equity price inflation that can’t be explaind by retained earnings. If it’s a speculative bubble it’s a likely cause of national under-saving, irrespective of whether you focus on households. But if it’s the result of a productivity or terms-of-trade windfall, then it’s just like a capital transfer, and it makes sense to treat it as an increase in real national wealth, from which we may claim an annuity. It’s still not income or saving in the national accounts, but it needs to be taken into account when we assess whether we’re saving enough as a nation. And the question in this case… how the hell do you tell the difference?

  13. The national savings numbers are junk.

    The RBA’s attempts to rehabilitate them such that they can be a useful indicator is long overdue.

    I cannot believe we have ignored equities and property as a store of wealth for so long.

    John,

    I agree with you that the transition back to ‘external balance’ (if there ever is one), might be painful. But then again, it might not be.

    Moreover, even if this is the case, this pain must be measured against that accumulating from the ‘stop-go’ cycles previously engineered in pursuit of external balance.

  14. John, I actually find the most persuasive paper in that bunch to be the one by Christian Gillitzer, Jonathan Kearns and Tony Richards, which made a pretty persuasive case that the so-called “decline” in volatility was really just due to better measurement of GDP. I showed their Figure C1 to my students when teaching this stuff earlier this semester. As macro graphs go, it’s pretty funny.

    It’s only a pity their title is so dull. The paper might better have been named “why we think our colleagues are confusing measurement error with reality”.

  15. It really is a bit weird that a CAD of 6% leads to interest rates of 18% but a decade later a CAD of 7% doesn’t bat an eyelid. When you think about it, its probably the single most important political and economic fact of the last decade.

    Excuse my ignorance, but why did we move to the assumption that CAD’s are not to be managed by the Reserve Bank? Were there some significant new economic discoveries? or is it just that people’s opinions have changed? The arguments I am hearing about consenting adults make the whole decision sound extremely arbitrary.

  16. It seems to me that if you give Australians that are most likely to save, generous tax deductions for borrowing and negative gearing they will do so in large numbers and amounts. Why would you not expect foreigners with low returns(or perhaps higher risk returns) elsewhere to bankroll such sound investments? The question is, whether the risk returns stack up. It seems to me that if the total annual rise in Australians’ wealth is greter than the rate at which they are borrowing (ie the CAD), then the latter can continue indefinitely. The only snag I see is the demographic one. At the end of the decade the first of the baby boomers hits 65 and some serious cashing out really begins. That’s not really a problem if lots of young skilled/business migrants from the saver countries, are poured in to take those assets off their hands at then current prices. Lots of ifs and consequently it’s pretty iffy to cash up your asset holdings now.

    Oh and for those ‘In Gold We Trust’ folk, I note that the shiny stuff has depreciated on average, 2.2% pa in real terms over the last 25 years. So much for gold standards.

  17. “how the hell do you tell the difference?”

    Well in theory the RBA should be able to do some sort of surveys of company accounts and measure total revenue and profitibility. If they ignore the actual share prices and make an assumption of some sort of linear like between revenue and profitibility and the worth of the shares they can at least get an idea of the relative increase in these gains if not the actual magnitude. Or instead of a linear relationship they could take into account interest rates with some sort of simple and transparerant equation. It would be far from perfect, but it would be objective and better than ignoring the gains altogether.

    This might be politically difficult though, as it would implicitly be a judgement on the real valuation of the stock market. I imagine the recaction of the finance industry to RBA valuations of the stock market that were way below current market values would be problematic, no matter how hard the RBA tried to paint it as merely theoretical.

    Still, if we’re supposed to be moving from wage based income to investment based income its only going to become a larger problem over time. They’ll have to deal with it sooner or later, and treating the equity valuations at face value is going to lead us all over the place. CPI housing costs are calculated using owner’s equivalent rent instead of actual prices. I don’t see why equity based savings should not be calculated using company earnings rather than current prices either.

  18. john,
    i get the sense that in recent weeks you have been hedging around the idea that the transition will not be smooth,
    your very well qualified questions hint at a nagging sense of unease for the forseeable financial future,
    but your scientific training and position of some responsibility pull you up,
    am i wrong?

  19. James Farrell Says: May 9th, 2006 at 6:33 am

    The second issue concerns equity price inflation that can’t be explaind by retained earnings. If it’s a speculative bubble it’s a likely cause of national under-saving, irrespective of whether you focus on households.

    I dont see how capital gains equal increased savings. It all depends on whether the capital price rises reflect improvements in real earning power or simply inflationary speculation. Surely the latter alternative cannot be ruled out, after NASDAQ 5000?

    OTOH, the commondity price boom does not look like a flash in the pan, given that IND/PRC are only 1/4 way through the process of modern industrialisation.

  20. smiths – JQ and his minions has been forecasting gloom and doom o the CAD issue for ages. It appears that the only reason they are doing this is because of their hatred of the Howard government – the can’t find any other numbers that could be politicised as bad numbers.

    How off his tree was P.J. Keating on the 7.30 report last night? Saying the governmment deficit didn’t exist because the Libs startd paying it off -said people can’t access super until 65, when in fact it is age 55 now with a scale up to age 60 for those born 1960 to 1965.

    Intersting to note that much of the imports, about 13%, are investment. Also, exports in ag products have recovered nicely and mining exports have been effected by weather issues (c’mon – bring on the Kyoto/Global Warming. . . oops make that Climate Change impacts – you know you want to.)

  21. Razor, on the politicisation of the CAD, I recall Peter Costello when he was in opposition touring the country with a debt truck to highlight the CAD and foreign debt, which were a whole lot smaller then than they are now.

    I guess it’s quite simple. Paul Keating’s CAD is bad, John Howard’s CAD is good.

  22. “the only reason they are doing this is because of their hatred of the Howard government ”

    Razor, before you make this kind of silly claim, you could check the public record, which includes this paper

    “Quiggin, J. (1992), ‘ Partial financial deregulation and the current account’, Economic Papers 11(1)”

    criticising the consenting adults view on the current account. For that matter, you could check my public comments on the Keating government’s economic policies in general.

    Feel free to argue, if you want, that the fact that I’ve been worrying about the current account deficit for fifteen years, and nothing bad has happened yet proves that nothing bad will happen. Fifteen years is a short time in economics.

  23. “The question is whether this adjustment will be smooth or painful.”

    JQ, since you’ve been a pretty consistent doomsayer on the issue of high CAD, can you tell us what your prediction is? Where will the pain be?

    Personally, I’m all for the consenting adults viewpoint; if the government applied that principle more universally we’d all be considerably better off.

  24. jquiggin Says: May 9th, 2006 at 2:22 pm

    Feel free to argue, if you want, that the fact that I’ve been worrying about the current account deficit for fifteen years, and nothing bad has happened yet proves that nothing bad will happen. Fifteen years is a short time in economics. …

    Now we have a deficit of 7 per cent of GDP (as do most other English-speaking countries) and no one worries. The assumption is that borrowers and lenders are consenting adults who can make their own decisions.

    We are all dead in the long-run. And the stock market can be irrational longer than you can be solvent.

    I take this to mean that Pr Q disputes the Pitchford thesis which argues that households, rather than Central Bankers/Treasurers, should determine the flow of credit and stock of debt.

    A nation’s international balance of assets/liabilities will rationally adjust to suit the costs and revenues that accrue to these instruments.

    Obviously there are times when this rosy view of private sector accounting does not pan out, eg the Asia crisis, Latin America etc.

    So Pr Q is assuming that private sector borrowers are acting under some kind of irrational financial illusion.

    Given that the East Asia offers a seemingly unlimited

    – supply of cheap credit to underpin our capital imports and

    – demand for expensive minerals to pay for our goods imports

    why is Pr Q so bearish about AUS’s capitalistic financing policies?

  25. John,

    I remain to be convinced about this, but am always open-minded.

    Is there any paper/source which sets out the theoretical linkages whereby a sustained and large CAD could lead to deleterious economic consequences under a floating exchange rate?

    (I mean excepting less-developed countries of the sort that Krugman described in ‘Depression Economics’)

    Or is it expected that the same mechanism may one day operate in the ‘rich’ countries to bring about the same sort of outcome?

  26. And whats with this “elephant in the room” metaphor? It should be “800 lb gorilla in the living room”! Thats the kind of thing I would be worried about.

  27. SWIO,

    Its a bit simplistic to suggest that the CAD of 6% led to 18% interest rates, for two reasons.

    Firstly, all sorts of other variables affect both interest rates and CAD (not least of which is inflation – try comparing real interest rates)

    Secondly, the causation could equally be argued to run the other way round (operating through the capital account and $A appreciation)

  28. Jack:

    “I dont see how capital gains equal increased savings. It all depends on whether the capital price rises reflect improvements in real earning power or simply inflationary speculation. Surely the latter alternative cannot be ruled out, after NASDAQ 5000?”

    Agree that it could be one or the other, but if we deflate asset prices by CPI (probably smoothed/moving averaged over some time frame) why should the resulting increases in net wealth NOT be counted as savings?

    If my apartments quadruple in value over my working life, and CPI only doubles, surely the difference is a net saving that I can spend in my sunset years?

  29. Chris, the standard presentation of a hard landing scenario is that of Obstfeld and Rogoff.

    There’s nothing peculiar to LDCs about the scenario. It’s only a question of whether lenders start to worry about the possibility of rapid depreciation, which most observers think is necessary for he $US at some point.

  31. It is an interesting shift by policy makers and Australian conservative politicians. Might we one day see a similar shift on budget deficits as has been the case for US conservatives? Do Turnbull, Davidson et. al. really believe in the supply-side impact of tax cuts?

  32. Geoff R Says:

    Do Turnbull, Davidson et. al. really believe in the supply-side impact of tax cuts?

    I don’t think anyone in power believes it. I’m not sure that anyone in power ever did believe it. It’s just a cover story, a way to give moral cover to a bunch of selfish bastards who want to push the burden of tax onto someone else.

  33. Spiros – the problem with the CAD was the $96 Billion of government borrowing.

    Now there is no net federal debt.

    That makes a huge difference.

    JQ – aren’t you going to feel good when you are able to say “I told you so!”.

    If foriegn investors are happy to lend to us then why shouldn’t they? i also don’t beleive that your use of historical averages is relevant. Domestic and international financial markets have transformed allowing much higher levels of debt to be carried than we used too.

  35. “If my apartments quadruple in value over my working life, and CPI only doubles, surely the difference is a net saving that I can spend in my sunset years?”

    We’re stuck with the fact that saving has two meanings: (1) production minus consumption, and (2) increments to wealth. Where the differerence between them is due to transfers, they will net out at some level of aggregation so that (1) and (2) are the same. But if someone discovers a new oil reserve or invents an engine that halves petrol consumption, the two measures of saving will stay different. We should stick with (1) in such cases, while noting that the both the level of wealth and its rate of depletion are important when we examine the current account.

    The quadrupling of your appartment’s value (I’d prefer to think you only have one, Chris) is a windfall to you as an individual, but it’s not like the oil discovery or the invention because it doesn’t increase aggregate wealth. The rise in your wealth is the capitalised value of rental (in the technical sense) income you will earn at someone else’s expense (Paul Watson’s?) in your twilight years.

  36. As for Razor, it’s amazing how one’s expectations adjust. To anyone who’s visited Catallaxy recently, Razor would now appear as a model of civility, humility and scholarly standards.

  38. The quadrupling of your appartment’s value (I’d prefer to think you only have one, Chris) is a windfall to you as an individual, but it’s not like the oil discovery or the invention because it doesn’t increase aggregate wealth. The rise in your wealth is the capitalised value of rental (in the technical sense) income you will earn at someone else’s expense (Paul Watson’s?) in your twilight years.

    If interest rates halved you might see property prices double even as rents stay the same. In which case the wealth is mostly an illusion rather than a reality. The property provides no additional income for the owner and gives no additional utility for the tenant.

  39. JQ,

    There’s nothing peculiar to LDCs about the scenario. It’s only a question of whether lenders start to worry about the possibility of rapid depreciation, which most observers think is necessary for he $US at some point.

    Would you agree that this, while fundamentally true, is in practice an oversimplification? The US is so disproportionate a component of global demand, and USD so prevalent as a reserve currency, it seems likely this will impart significant differences on the behavior of creditors, international institutions, etc. in comparison to what we’ve witnessed with the LDCs, (indeed that it already has). At a minimum, there is the sheer scale of the financial institutions at risk of failure, (I would say likely to fail) with financing operations crisscrossing the planet. Also markedly different: the US will not be in a position to inject liquidity to stem the crisis, which points to a non-dollar liquidity injection in the extreme, if such a thing can even be organized. Perhaps I should sell my gold and start stockpiling shotguns and cans of peas.

    As an aside, it occurred to me that the Chinese $900 bn pile of NPL’s doesn’t fit nicely with the ‘consenting adults’ view of current account deficits. Somewhere a Harvard professor is authoring an addendum to the theory citing evidence of dark matter in the brains of Chinese loan officers.

    Chris C, fyi, my response to you on the other thread was held up by the auto-moderator. It’s there now in all its many words if you’re so inclined.

  40. A fall in the interest rate improves the terms of trade for borrowers to the disadvantage lenders. As you imply, Chris can only benefit from this capital gain if he sells the house and consumes the proceeds in the present. This would make him a borrower in the sense that he is exchanging his title to the future income stream from the appartment, for a basket of goods in the present. The person who buys Chris’s appartment now is a lender in that she is exchanging current goods for a stream of future accommodation services. So the lower interest rate merely redistributes wealth between the parties, and doesn’t affect aggregate household wealth (except to the extent that foreigners are buying real estate). Which is not say it won’t affect consumption. Households are not that rational.

  41. Majorajam, you’re quite right. The size and importance of the US changes things in a couple of ways. On the one hand, it can get away with things, like bad fiscal policy and huge current account deficits, that would have the rating agencies downgrading a banana republic. On the other hand, its size is such that the capacity of the world to finance its borrowing must run into a limit some time.

  42. Majorajam, JQ:

    Is it reasonable to conclude from your comments about the nature of and significance of both the US government and private credit providing institutions in the world’s credit market that the following are missing:

    1. information feedback mechanisms that may discipline smaller, more vulnerable nations and credit providing institutions.

    2. non-$US liquidity that may soothe the market during periods of fear about the capacity of the US government and private credit providing institutions to service their debt.

    I have two questions:

    1. Is it useful to make some distinction between the relative vulnerability of the government and private institutions in the above formulation?

    2. Given the lack of information feedback, any break in creditor confidence and capacity to continue to provide credit would be still more difficult to predict. But are there signs that might serve as an early warning system for the break described by JQ above?

  43. Majorajam,

    Have posted in the other forum – I think we agree on at least some of the important points.

    I suppose in general (and this is relevant to this forum too), I see international trade and capital flows merely as extensions of their domestic equivalents (complicated slightly by exchange rates).

    Hence, I do not understand why ‘external balance’ in of itself is an issue under floating regimes, except inasmuch as it leads to domestic imbalances in credit growth vis-a-vis real productive capacity.

    If this is the issue everyone is talking about, fine – I accept.

    However, having read the Obstfeld/Rogoff paper, I believe their main argument is that given current ‘imbalances’ any $US depreciation is going to have to be whoppingly big to balance their CAD (around 33%).

    My response is:

    1) So what? The $US depreciated in the order of 40% after the ’85 Plaza Accord and the world was not annhiliated.

    2) Why does their CAD need to be balanced in the short term anyway? Australia has run a CAD since 1974 and for much of that time it was fairly large. We’re still here. I think Terje’s retirement village analogy is appropriate here.

    On this point, as Prof Quiggin has pointed out, there will come a point where the increase in their CAD becomes almost automatic and exponential (cet. par.), but to me it is obvious what will happen at that point.

    The $US will dive (as the Rogoff-Obstfeld model predicts), T-bondholders will get their fingers burnt, world interest rates will rise, and the yield curve will ‘get normal’ again.

    Wheres the calamity?

    Regarding the national savings issue, it all depends what we are trying to get at. I raised the apartments example to show that capital gains are actually real savings (to the extent that they outcpace inflation) for an individual, if they are realised and the proceeds then support an individual in retirement.

    But I would suggest that in these days of floating exchange rates, a country like Australia would never raise enough capital domestically to exploit all profitable investments, so what is wrong with us running a capital account surplus (and its corollary, a CAD) to do this?

  44. Majorajam,

    You say:

    “Also markedly different: the US will not be in a position to inject liquidity to stem the crisis, which points to a non-dollar liquidity injection in the extreme, if such a thing can even be organized.”

    Why wont the US be able to inject liquidity, as the BOJ has done over the last few years?

  46. Chris you do the following:-

    (blockquote)
    indented text being quoted.
    (/blockquote)

    However instead of curved brackets you use angle brackets (ie less than and greater than symbols).

  47. Chris C,

    I don’t have the time to write a more detailed response, but some of your post I have already discussed here. I would just briefly comment on this:

    The $US will dive (as the Rogoff-Obstfeld model predicts), T-bondholders will get their fingers burnt, world interest rates will rise, and the yield curve will ‘get normal’ again.

    John Dizard amongst a few other astute commentators had the view that it was a given that, in such a rout of the bond markets, Fannie and Freddie’s derivative portfolio would explode whatever institutions were on the other side of it (wittingly or otherwise). This remains a not unlikely scenario with the caveat that since that time, their balance sheets have not grown as aggressively due mostly to unrelated regulatory scrutiny. The balance sheet growth they have seen has taken the form largely of the shorter-term mortgage products (ARM, option ARM, negative amortization, etc.), all the rage in the US as homebuyers and speculators have consistently reached for the most home they could grasp, (if momentarily). This to some degree takes the pressure off of their counterparties and puts it squarely back on them. In any case, they are pretty large institutions to go bye bye. They’re the same ones that primarily funneled Fed-liquidity into the world economy following the Asian contagion and

    Keep in mind, a spike in interest rates is no benign event. First and foremost, it is very likely to trigger panic in the asset markets and concomitant full scale deleveraging. In any case, it puts a heavy load of stress on traditional intermediation as defaults spike and lending activity is crushed. When you add to that circumstance a currency crisis, things go from bad to worse. This is where you often get capital controls and emergency laws keeping people from their money. Otherwise, you get bank runs as citizens along with everyone else want to trade in what’s left of their savings before its purchasing power is completely obliterated.

    The point is that this time could not be more different than 1985. In 1985, the US CAD was half of what it is today- the US NIIP was in far better shape than it is today- total debt (public and private) to GDP was a fraction of what it is today (which in the US is currently higher than it has been for at least a century- including at any time before or after the Great Depression)- asset based leverage was a pittance by today’s standards- all major trading partners were willing to cooperate on the exchange value of USD- derivatives and hedge funds were a fraction of their representation- etc. etc. etc.

    PS you should also read the second passage on Hoover – you may find it interesting.

  48. Majorajam,

    I think we then agree that external balance is only important inasmuch as it feeds through to credit creation, and the potential consequences?

    Fine, I’ll accept that.

    As for your argument that the USs unprecedented CAD will most likely lead to a world crash, I find that a step too far.

    And I still maintain that any central bank is able to pump unlimited liquidity into their economy (as long as there is paper to print the notes), and is thus capable of preventing the aforementioned crash.

    I did not read your original links on Hoover because I could not find these – but I certainly did find the cited passages interesting. Although arguably the US economy in 1929 needed a much greater stimulus than a 2.25% interest rate cut.

    Also, from recollection, Hoover desperately tried to balance the budget, despite what is cited in that passage – is that not correct?

  49. The “elephant in the Room” metaphor was stolen off right wing columnist Mark Steyn.

    He cam up with it 6 mths ago

  50. Wikipedia cites an instance from 1989, so I very much doubt that what you say is true.

    Anyway, Keating had a better one the other day:

    In the end the economy is going to slow up, because fundamentally the Government’s done nothing about the real debt. I don’t mean the easy debt the one you pay off with Telstra sales. I don’t mean that one. I’m talking about the real one, the elephant around the carpet one.

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