My apologies to Brad Setser for borrowing the title of his blog for the evening.
I am writing tonight while on vacation at a cabin in Central Oregon. I do not have high speed internet access, reverting instead to a telephone modem. Consequently, I have left out some links that I would normally include. Not exactly my most polished piece either. And I probably shouldn’t even be working; it is just my son and me tonight, and he went to bed hours ago. A wise man would have followed and taken the rare opportunity for extended sleep, but I had some stories I just could not get out of my head, so better just to write them down.
During my brief stint at the U.S. Treasury, an economist visiting from Australia requested an informational meeting with some Treasury staff to discuss the results of a paper he was in the process of writing. I recall this visit occurring during the height of the Asian Financial Crisis, about the time that JP Morgan issued a US recession call on the basis of an expected widening of the trade deficit. This economist, whose name I can’t recall, said that a US recession was simply not going to happen. Instead, he predicted that a wave of capital would flow out of Asia to the US, pushing down long term interest rates, which the Fed would accommodate at the short end. The end result would, he anticipated, be highly stimulative.
Not exactly conventional wisdom at the time, but needless to say, this turned out to be a remarkably accurate prediction; the capital flow into the U.S. found traction in the already smoldering information technology sector. The rest is history, both good and bad. The lesson I took away from this episode was to drop your preconceived ideas about what you were sure would happen and just follow the money and see where it leads.
The technology boom was characterized by high rates of investment spending, and although the final push that followed the Asian Financial Crisis saw plenty of excess, one could reasonably argue that the capital inflow was supporting investment spending. This, of course, is the traditional textbook interpretation of a current account deficit/capital account surplus as a mirror of an internal saving and investment imbalance.
I recall one person, however, who was not so convinced. His name also escapes me, but I am pretty sure he was real. He worked for a conservative think tank, and was diligently writing a book on the US trade deficit. I recall attending two think sessions that he organized for people in the policy community to comment on his results, many of which were pretty standard criticisms of sustained, large external imbalances. But I do remember one important distinction – he had the temerity to suggest that those capital inflows were not just supporting investment, but were supporting household consumption. Someone (just to prove I remember something, I am almost certain I could testify in court that it was Catherine Mann, who at that time was at the Institute for International Economics), challenged this, noting that it ran against traditional wisdom.
I will never forget his response: Banks are busy refinancing mortgages, explicitly encouraging homeowners to withdraw equity in the process. These mortgages are then packaged up into mortgage packed securities and sold to overseas investors. In other words, he drew a direct link from an investor in say Zurich to the guy down the street buying a new TV. This insight came in 1999 or 2000. Maybe 2001. The year is not that important, it was simply a long time before most people caught on to this dynamic. Following the money can lead you to unexpected places.
The point of these stories is that while we know capital is flowing into the US, we don’t always know where it will end up; I am not convinced it even has to stay in the US. Since 1980, those capital inflows can be tied to government deficit spending, investment spending, and household consumption. So I now characterize the US current account deficit as simply reflecting an excess of consumption over productive capacities, while often remaining agnostic as to the ultimate demanders – firms, households, or the government – of that consumption. That excess consumption, regardless of the demander, will put a strain on global resources if the rest of the world is unwilling or unable to provide for it.
In the comments to my last piece, Bill Connerly essentially notes that I am using the term consumption loosely as it typically refers specifically to the activities of households:
Tim's comment that we consume more than we produce is not true. We consume plus invest more than we produce. One could just as easily argue that we invest too much as that we consume too much. And yet, we don't mind countries running a trade deficit in order to invest. The U.S. did that in much of the 19th century with pretty good results.
I am wary of the view that capital inflows are simply an innocuous side effect of an effort to sustain high levels of investment spending. This may be true as a general rule in a world of largely private direct investment. But in a world of hot money flows? And flows directly tied to household spending? And as Brad Setser has repeatedly warned us, the vast majority of the net inflows are from the official sector, which clearly has a non-investment objective. Indeed, foreign capital is still being funneled directly to households, just via US Treasury debt rather than mortgage debt.
So, if we follow the money, where does that lead us? Everyone wants to know the answer to that question. I think that it will be difficult for capital inflows to gain traction in the US, essentially the same problem left in the wake of the 2001 recession. Lacking that traction, the money seems to be flowing into commodities. To halt the rise in commodity prices, I suspect that either global monetary policymakers needs to tighten meaningfully or, what I think the Fed is hoping for, the money will spontaneously shift to another, less inconvenient direction, optimally some real, productivity enhancing form of investment. Until we see one of those outcomes, I tend to fall back on that old Wall Street truism: The Trend is Your Friend.
Which is why, as I was leaving for vacation just before the market close, I was not surprised to see oil hovering around $145 and, as also noted at Across the Curve, the 10-years TIPS breakeven had broken out to 261bp. All on the back of a weak, weak jobs report.