By Ron Rimkus, CFA
Recently, U.S. Federal Reserve Chairman Ben Bernanke removed all doubt about whether or not the Fed would proceed with QE3. It’s happening. Officially, the Fed announced plans to purchase mortgage-backed securities of up to $40 billion per month (or about $480 billion per year) and to maintain a zero-interest rate policy (ZIRP) until mid-2015. Notably, this QE is open-ended, lacking any definition about the duration of the program.
QE3 is certainly substantial, but why should we expect this to work more than its predecessors? QE1, it can be argued, restored liquidity to a collapsing banking and shadow lending market by pumping $1.45 trillion into the agency and MBS markets. Importantly, this was a definitive, deliberate attempt to prevent a collapse. Under QE 2, the Fed pumped $600 billion into the U.S. Treasury market with a focus on bringing down interest rates. However, both QE1 and QE2 had short, definitive lives. It seems to me that QE3’s open-ended nature is more like the U.S. current account deficit, in that it will channel money into the bond market in an open-ended way.
Wait a minute, the current account deficit? What’s that got to do with QE3 and interest rates? A lot, it turns out: in many ways the long-running current account deficit, and its mirror image, the capital account surplus, are kind of like the prequel to quantitative easing. We’ve seen this movie before. And like a low-budget horror franchise, each release (in this case, of liquidity) seems destined to deliver less impact. Let me explain.
Back when I was in business school, I floated a very pointed question to one of my professors, a well-regarded economist and econometrician. “So, what’s the big hullabaloo about the current account deficit?” I asked. This was in 1997. I’ve never forgotten his answer: “The current account deficit is the most misunderstood thing in all of economics,” he told me. “When you have a current account deficit, you simultaneously have a capital account surplus. It’s an accounting identity. So, in effect, the current account deficit means that other countries are loaning you money. That loan is invested and it all depends whether or not you get a return on that investment.”
That answer never squared with me, and I didn’t know why ... until the financial crisis that presaged quantitative easing swept through global markets.
Here’s how the current account deficit really works: A U.S. consumer goes into Wal-Mart to buy, say, a refrigerator. The consumer gives Wal-Mart $1,500. Wal-Mart keeps $500 for itself (as gross profit) and sends $1,000 to a Chinese manufacturer. Because Chinese people and businesses have no direct use for U.S. dollars, they exchange them for Chinese renminbi with their local bank. Eventually these dollars find their way to China’s central bank (as banks exchange foreign currencies for local currencies). China’s government then has a choice: keep the dollars or sell them on the currency market. If the government sells them on the currency market, it drives the value of the dollar down and the value of the renminbi up relative to each other (all else being equal). This change in currency values would harm Chinese exports by making them more expensive and help U.S. exports by making them cheaper. This is the natural imbalance correction mechanism under the current floating exchange rate system.
Alternatively, if the Chinese choose to keep the U.S. dollars, they must then invest them in something denominated in dollars. For many years, the vehicle of choice was U.S. Treasuries, so much of the current account deficit wound up in the foreign purchase of U.S. Treasury bonds - pushing U.S. government bond prices up and their corresponding yields (that is, interest rates) down. This exchange created a positive feedback loop, in which the more the trade imbalance grew the more U.S. Treasuries were bought, and that drove interest rates downward. As interest rates fell, credit expansion continued, the economy grew, and the virtuous cycle was created.
Except for one fatal flaw: It was unsustainable. Rather than being a true virtuous cycle, it was more like a morphine binge - you feel good for a while but then you must pay a steeper and steeper price as the addiction grows. Of course, this morphine binge is global insofar as many countries run persistent deficits or surpluses, and few are in balance. Interestingly, this phenomenon enables both trading partners to take on more debt than they otherwise would as both economies are goosed. But make no mistake, debt cycles don’t last forever - even when the investments are good. And today, there is a very sketchy record of mal-investment ranging from America’s housing bubble to China’s ghost cities to all the other debt-fueled investments that have been given a green light in the wake of easy money.
The preceding discussion, of course, describes what happens with the exchange of goods. But that is only part of the story. The current account is comprised of four components: goods, services, income payments, and transfers. So let’s take a look at the whole enchilada:
United States: Annual Current Account Surplus (Deficit) (Dollars in Billions)
Sources: St. Louis Fed, CFA Institute.
As illustrated in the graph, our current account deficit reached a massive $200 billion in the red in 2006. Whoa. That’s larger than most industries. What this means is that the United States “gave” foreign countries $200 billion more than these countries gave the United States. Much of the $200 billion was invested by these foreign countries in U.S. Treasuries (as well as agencies and MBS), thus contributing to former U.S. Federal Reserve Chairman Alan Greenspan’s famous puzzlement over low rates as well as the U.S. housing bubble.
Perhaps my professor could still argue that he was right - that other countries are simply “loaning” the U.S. money. But as my description shows, his answer conceals the mechanics at work. There is no reason to suggest that the current account deficit necessarily translates into a loan versus some other asset. For instance, the Chinese can do anything they want with the dollars they receive; they certainly don’t have to invest them in U.S. Treasuries. They can sell them (as mentioned), they can buy U.S. Treasuries, or they can invest in a wide range of U.S. dollar-denominated assets, such as U.S. stocks, real estate, commodity companies, etc. In fact, despite ongoing trade deficits with the United States, China has quietly been shrinking its holdings of U.S. Treasuries. As it happens, Japan has stepped up its purchases of Treasuries, largely offsetting the selling from China. Of course, China is aware of the “special relationship” it has with the United States - so it can’t simply liquidate all of its holdings of U.S. Treasuries without harming its own economic growth. Nonetheless, global mal-investment spawned by the credit bubble is massive, and the major economies of the world have generally not dealt with these problems, choosing instead monetary and fiscal stimulus in order to grow GDP.
That other, more powerful effect of the current account deficit is worth reemphasizing: Large-scale purchases of U.S. Treasuries, agencies and MBS have pushed rates below where they otherwise would have been, providing monetary easing to the U.S. economy. In the early 2000s, the persistent U.S. current account deficits effectively goosed growth in GDP - for both the United States and its trading partners. Moreover, because imbalances are unsustainable, persistent trade imbalances are at the heart of today’s global debt crisis, particularly in the eurozone. For instance, that means that countries that take on U.S. dollars through a current account surplus and buy U.S. Treasuries don’t need to sell them, thereby preventing the U.S. dollar exchange rate from adjusting. Hence both economies get thrown off balance. However, whether it comes from specific Fed policy (e.g., QE3) or from the current account deficit is a moot point. Why? Because money neither knows where it’s going nor where its been. It’s just money. There are only three relevant questions: Where exactly does the bubble end up? How big will the bubble be? And how much does money supply expand? As a point of reference, the U.S. current account deficit reached its peak in 2006. However, the impact of all that money flow is cumulative: Trading partners are not forced to sell their U.S. bonds at the end of each year.
Let’s look at the U.S. current account deficit on a cumulative basis to gain an understanding of how large the problem is:
United States: Cumulative Current Account Surplus (Deficit)
Sources: St. Louis Fed, CFA Institute.
That’s right, $8 trillion! Exactly how much of that $8 trillion ended up in the U.S. government bond market? I’ll leave that for another post. But with the U.S. government bond market checking in at about $15 trillion today, it is very likely that a significant portion did. Moreover, from U.S. Treasury reports, we know that holdings of U.S. Treasuries by foreign governments are substantial. With ever-increasing current account deficits since 1980, debt became its analog - even continuing total credit expansion through recessions. Of course, as banks were forced to lower their credit standards due to government policies, the acceleration of the current account deficit in the early 2000s led directly to an acceleration in housing and bad mortgage loans - leading to the financial crisis of 2008.
So, why should we expect QE3 and its attendant ZIRP to perform any differently? As noted previously, the Fed has just committed to buying $40 billion per month, or $480 billion per year, which compares to the annual current account deficit’s peak of only about $200 billion in 2006. Relative to the existing U.S. monetary base of $2.7 trillion, the $40 billion per month of new money translates into an 18% year-over-year increase in the monetary base. How efficiently that translates into money supply is difficult to say, but it is fair to say that it goes up materially.
Is it any wonder that we experienced the Great Moderation through the 1980s, 90s and early 2000s in which the business cycle was seemingly mollified and tamed thanks to supposedly great U.S. Federal Reserve policy? The immediate consequence was lower volatility. But that was then, and this is now. Today, we have a world that has hit its limit of total debt. Despite massive stimulus and additional easing, the economy reacts sluggishly, if at all. Consequently, the effects of financial leverage will, as we move forward, be much more volatile than most investors can remember.
So what does this all mean for investors? I see three key takeaways, brought into ever-sharper relief by the onset of QE3:
- For starters, high volatility is part of the new regime, meaning that volume is probably cheaper than most models will predict. Can you say Black Swan, anyone?
- Second, QE3 will lead to more inflation and more debt. While it can goose the economy in the short term, it will heighten the downside in the long term. Waiting until the next major event unfolds is a recipe for failure. Whatever your opinion or investment strategy, position yourself before any events take place.
- Last, run payoff tables on everything. Consider both probabilities and payoffs. The magnitude of possible outcomes will be great. The new normal is a lot less normal than you might think.
In trying to make sense of today’s economic quagmire, there is one thing that I agree on with my esteemed professor - that the current account deficit is the most misunderstood thing in all of economics.
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