29 December 2008

Dancing on a Precipice: The Tenuous Balance in Global Finance

“If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem.” Jean Paul Getty
We imagine J. Paul Getty would probably like to update that quotation to billions if he were still alive. We knew some people who subscribed to this notion that you keep borrowing until you gain a measure of control over your banks, since your default would be so painful to them. It is a tool of financial engineering roughly related to a passive form of extortion, a long con.

Here is an extended quote from a 29 December 2008 essay by Brad Setser titled The collapse of financial globalization...

"Both private capital inflows to the US and private capital outflows from the US have fallen sharply. They have gone from a peak of around 15% of US GDP to around zero in a remarkably short period of time …

Direct investment flows have continued. Other financial flows though have largely gone in reverse, with investors selling what they previously bought. In the third quarter foreign investors sold about $90b of US securities (excluding Treasuries) and Americans sold about $85 billion of foreign securities. And the reversal in bank flows on both sides (as past loans have been called) has been absolutely brutal.

This sharp fall has bearing on the bigger debate over the role global capital, global savings and foreign central banks played in helping to to create the conditions that allowed US households to sustain a large deficit for so long — and whether American and other policy makers should have paid more attention to the risks that came with the surge in foreign demand for US financial assets earlier this decade...

I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system.

It was a largely unregulated system. And it was largely offshore, at least legally. SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing. European banks that had a large dollar book seem to have been doing much the same thing. The growth of the shadow banking system consequently resulted in a big increase in gross private capital outflows and gross private capital inflows... (Hence the subsequent spike in the value of the dollar from the eurodollar short squeeze we have recently seen - Jesse)

Why didn’t the total collapse in private flows lead financing for the US current account deficit to dry up? That, after all, is what happened in places like Iceland — and Ukraine.

My explanation is pretty straightforward.

Central banks were the main source of financing for the US deficit all along. Setting Japan aside, the big current account surplus countries were all building up their official reserves and sovereign funds — and they were the key vector providing financing to the deficit countries."

The implications of this are rather profound. The much touted notion that the US is the preferred destination for private wealth, thus sustaining an out of balance trade deficit through a financial services economy, is rubbish at best, and propaganda at worst. It is rooted in the Dick Cheney nostrum that "Reagan proved that deficits don't matter."

What we have today is a very lopsided vendor financing arrangement, wherein the US is largely supported by China and Japan whose industrial policy currently recommends their support of a US debt that is increasingly unpayable.

If and when China and Japan are no longer able to support the continued growth of US deficit financing, the dollar and the bonds will contract (decrease) in value, and perhaps precipitously, like a house of cards. It is much worse than we had imagined, and more concentrated on these two countries, along with Saudi Arabia, than we had thought.

For now the balance is maintained because of self-interest and fear. But we cannot stress enough the highly artificial nature of the arrangement, and its inherent instability, now that the charade of sustained private investment flow is shown for what it is. There is no economic theory to support this model other than a distorted form of neo-colonial parasitism. Substitute US paper dollars for opium and you get the idea.

Japan and Saudi Arabia are understandable as virtual client states under US military protection, but we struggle with how China was taken into this arrangement which is so potentially destabilizing of their internal political and economic stability.

This is why the world has not developed a sound replacement for the dollar hegemony. It is because if they do, they must navigate around the probability, not possibility, of a collapse of their dollar reserves, and a dislocation of their own export driven economies, much worse than we might have imagined. It is not a matter of economic inventiveness; it has become a matter of will.

Who will be the first to flinch? History shows it is rarely a conscious decision, but rather some incident, an accident, some trigger event, even one so small, that it creates astonishment at the size of the avalanche it unleashes.

To make it clear and simple, this is the first evidence we have seen to suggest that hyperinflation is in fact possible in the US. As you know, we have been strongly adverse to the extremes in outcomes, both in terms of a sustained deflation and a significant hyperinflation.

That has now changed. The dollar is a Ponzi scheme, the waters of debt are overflowing the dam of artificial support, and only a few countries, two of them somewhat unstable, are holding back the deluge.