Category: macroeconomics

The dollar, that's for sure. Even with the Loonie. A new low against the Euro. Paul Krugman asks if this is the Wile E. Coyote moment. I have a general view about what happens to the economies of large countries.

In almost all cases, the sky is not falling. Prices adjust so that it hangs lower and grayer.

Expect the dollar to decline until the U.S. current account imbalances shrink substantially. Expect some of this decline to happen as major exporting countries become less willing to organize themselves around holding dollars in exchange for their goods. Expect these countries to diversify their new investments and some of their existing ones, but not to dump their dollar holdings. No other country's short-term economic interests are served by devaluing its own asset holdings, and no exporting country's long-term economic interests are served by inviting a nationalistic, political response from the U.S.

In the wake of last week's market volatility, Senator Clinton made a speech on the floor of the Senate and sent a letter to Chairman Bernanke and Secretary Paulson. Greg Mankiw characterized one part, appropriately in my view, as xenophobic. PGL at AngryBear responded with other parts that were, in his view (and to a lesser extent, mine) appropriately critical of our current macroeconomic policies.

The main problem with Clinton's argument is that there is no particular connection between the amount of U.S. debt that China and Japan hold and what happened last week. Is she really saying that the U.S. market wouldn't have dropped after the Chinese market dropped if we ran a trade surplus with China? Or if we still ran a deficit but China's resulting portfolio holdings were in some other country's federal liabilities rather than ours? Our economy is connected to the Chinese economy via both current account and capital account transactions. We might want to be more mindful of the latter than we have been. But that doesn't mean that the high ownership of U.S. debt by China caused the transmission of price movements from China to the United States.

Read this excerpt and see if she actually justifies the leap she makes in going from the red to the blue sentences below:

I have long argued that a great source of vulnerability is the fact that other countries, including China, own so much of our debt. Today, foreign nations according to the most recent Treasury statistics hold over $2.2 trillion or 44% of all publicly held United States (U.S.) debt with Japan and China alone holding nearly $1 trillion. In essence, 16% of our entire economy is being loaned to us by the Central Banks of other nations. Having so much debt owned by other countries can be economically unsound. Yesterday it was the sell off of foreign stocks that had reverberations in U.S. markets. But if China or Japan made a decision to decrease their massive holdings of U.S. dollars, there could be a currency crisis and the U.S. would have to raise interest rates and invite conditions for a recession. While it can and will be debated whether yesterday's market disruption was just a blip or a larger indicator of our economy's vulnerabilities, it is clear that interdependence between our economy and that of other nations can pose a risk if we do not pursue smart policies. Precipitous decisions by any country with our debt could create much graver economic problems than what we saw yesterday. The writing may not be on the wall, but yesterday, the writing was on the Big Board.

Her "in essence" sentence is not a sensible comparison. It does not make sense to compare a stock of money--the total holdings of U.S. federal debt by foreign investors--with the flow of money that is U.S. GDP. A sensible comparison might be the flow of interest that we pay to these foreign investors, a much smaller number as a share of GDP. (For example, I don't get too worried about the fact that a bank has lent me more than 100% of my income in the form of a mortgage. The reason is that the interest on that mortgage is a very reasonable fraction of my income.)

The statement in green above is a true statement. Not only would the problems be more grave--they might actually be problems and be related to what the creditor nations did. But even this scenario that she discusses is, in Mankiw's word, alarmist. There would have to be a reason why China or Japan would intentionally precipitate a selloff of their holdings of U.S. debt, particularly since the Chinese and Japanese holders of the debt would be the first ones to suffer the capital loss due to this action. It couldn't simply be that their own economies faltered--the U.S. debt they hold is an asset to them. When my income falters, I am typically quite grateful for the assets I have in the bank (somebody else's liabilities). Their economies would have to falter so badly that they needed to liquidate their holdings of U.S. debt to pay off some of their own debts. Not too likely, unless, perhaps, we close our markets to them.

Clinton's rhetoric, particularly these statements about being "held hostage" or "losing our economic sovereignty," suggest that she's thinking about a scenario in which a policy maker in Beijing or Tokyo decides that the U.S. debt is overvalued and wants to unload it en masse. About the only thing that could really convince me to do this, were I the policy maker in Beijing, is a credible belief that my counterpart in Tokyo was about to do the same thing.

While that is something over which Washington has very little control, even in that case, all that would happen--unless you think the U.S. government wouldn't pay the interest or principal on its obligations--is that the U.S. dollar would depreciate and domestic interest rates would rise. Exports would pick up a bit, and the government would find deficits more costly to finance. I'd prefer if that didn't happen, but in the grand scheme of things, it's neither very likely to happen nor very severe in its real consequences if it does.

Barry Ritholz wonders today about the spike in his blog's traffic yesterday as markets around the world were losing value. I admit that I contributed to his site's traffic as I used these three posts to explain to my undergraduate finance theory students how to try to make sense of large market movements. We are passed the lectures on bubbles, noise trading, and herd behavior, and so we spent only a little time assessing what occurred.

In the first of these linked posts, Barry contrasts the explanation based on China's 8.8% drop with other events that also occurred yesterday, including news stories related to subprime lending and the weakness in the Advanced Durable Goods report. I don't buy any explanation based on China--its stock market is too small, the effect on other Asian markets was not particularly large, and weakness in the Chinese economy would indicate that we are likely to be able to run our trade deficit with China at lower cost. That shouldn't be bad news. I don't know enough about the subprime lending issues to know how important they were--I think it's a fairly marginal part of the real housing sector, so I'm skeptical there as well.

That would leave us with the weakness in durable goods. If this is to be the explanation, then it is interesting that it generated a downward movement. Typically, when there is unexpected strength in the other major monthly economic releases like GDP and Employment, the market does poorly. The rationale is that unexpected strength in the economy will make the odds of a Fed increase in short term interest rates more likely. That increase, in turn, depresses stock market values. The same process, probably to a milder extent, should operate in reverse for unexpected weakness in the macroeconomy.

So this durable goods report was unexpected weakness--why didn't the market hold steady or even go up? According to this view, the answer would have to be that, unlike GDP and Employment, the Durable Goods report also tells us directly about economy-wide investment and thus future business growth. So weakness there could be greeted not just with the lower inflationary expectations but lower profit expectations as well. Plausible--a good event study to do for an undergraduate finance major, perhaps.

My preferred explanation is that we have plenty of investors, both individual and institutional, who treat stock markets like a speculative exercise. There is noise trading and herd behavior aplenty, and so a drop of over 3% in the U.S., and larger drops in more thinly traded markets, shouldn't be all that surprising. I didn't even check my portfolios yesterday.

Via the Opinionator, here are some anecdotes from Daniel Gross about the way some professional investors in China viewed the events:

Special World is Flat bonus anecdote. Note the way Chinese analysts have quickly assimilated the technique, developed over several decades by U.S. analysts, of using fatuous cliches to explain baffling market activity.

''The most important reason for today's decline was pressure for profit-taking,'' said Peng Yunliang, a senior analyst at Shanghai Securities.

''People viewed 3,000 as a psychological benchmark. It's understandable they might want to pull back after the market hit that peak,'' Peng added.

It truly is a global capital market.