Global Central Bank Focus

Twice Blessed

"I don't worry about whether the current account deficit is sustainable, but rather how long the unsustainable can, in fact, be sustained."

I worry a great deal about America’s current account deficit. But not for the same reasons that many others – including many of my esteemed partners – worry about it. They worry that the deficit is unsustainable; in the long run, that is inarguably true. Also, in the long run, we are all dead, as Keynes intoned. Thus, I don’t worry about whether the current account deficit is unsustainable, but rather how long the unsustainable can, in fact, be sustained. To wit, what happens before we die?

The argument as to the unsustainability of the current account deficit is really quite simple:

  • Americans spend beyond their means, consuming more than they produce, importing the difference from foreigners (a current account deficit), with foreigners financing the difference (a capital account surplus).

  • There must be a limit to foreigners’ willingness to grow their stock of claims on the United States. And when that limit is reached, there will be a day of reckoning for America: a lower dollar, which will generate higher inflation, push up interest rates and thereby retard American hedonism.

  • This limit has been reached with respect to foreign private investors, who are presently refusing to fund America’s current account deficit, requiring foreign official investors – central banks – to massively buy dollars to keep it from plunging.

  • Such massive (unsterilized) foreign-central bank dollar buying cannot be sustained indefinitely,because it will lead to excessively loose monetary policy in foreigners’ countries, generating asset price bubbles and/or inflation in goods and services prices.

  • Thus, America would be wise to preemptively take steps to shrink its current account deficit,  notably tighter fiscal policy (reducing public sector dis-saving) and tighter monetary policy (reducing private sector borrowing).

It’s an old argument, one that I’ve heard in one form or another for my entire 20+ year career:

The figure is a line graph showing the U.S. net official assets flow, expressed on the left-hand vertical axis as the four-quarter moving average, from 1973 to 2002. By 2003, the graph shows net flows reaching a new chart high of about $42 billion, up steeply from about zero in 2001, and from negative $15 billion in 1998. The chart shows a general rising long-term trend, with net flows ranging between negative $2 billion and positive $12 billion from 1973 to the early 1990s, before the metric breaks out of its range, reaching $35 billion around 1996. It then declines to its 1998 bottom, before moving to new highs by 2003. Superimposed on the chart is a dashed line showing the trade-weighted U.S. dollar index, which tends to move in the opposite direction over time. By 2003, it has declined to about 90, down from 110 in 2002.

America is dependent upon the kindness of strangers, who might not always be kind, so Americans should get their collective financial houses in order. Preemptive Calvinism, if you will.

I‘m not a buyer of this line of reasoning, for a simple reason: the global economy has massively unused and underutilized resources, particularly human resources. Accordingly, the world faces no danger whatsoever of corrosive inflation – too much money chasing too few goods. On the contrary, the dominant risk scenario in the global economy is too many goods chasing too few buyers.

As long as this is the dominant risk case, there is no rational limit to foreign central banks’ ability to buy dollars, if and when private investors don’t want to fund America’s current account deficit at (1) the prevailing price for dollars and/or (2) prevailing dollar-denominated asset prices.

America is not hostage to the kindness of strangers, but rather, hostage to strangers acting in their own best interest: choosing to print their currencies to buy dollars, so as to prevent/temper appreciation of their currencies, which would impart a deflationary bias to their domestic price levels, while frustrating efforts to more fully employ their under-employed peoples. It really is that simple.  

When Ink is Free
But you ask: Don’t foreign central banks lose money on their dollar reserves when the dollar goes down? And isn’t their refusal to let their currencies appreciate robbing their consumers of the proper purchasing power fruits of their labor? The short answer on both scores is yes, but the fuller answer is that it doesn’t matter, at least in the short- to intermediate-term. Currency intervention is not a symmetric affair: protesting an appreciating currency is very different from defending a depreciating one!

A central bank resists appreciation by printing its own currency, whereas a central bank resists depreciation by selling appreciating currencies that it owns or has borrowed. Very different! In an economic sense, a central bank cannot lose money by printing its currency, even though it can from an accounting perspective (if it buys something that goes down in price, measured in its own currency). The beauty (or bane) of a fiat currency is the power to create nominal purchasing power for nothing! And when there is a shortage of global purchasing power, as manifest in unemployed and underemployed global labor resources, it is the duty of central banks to create nominal purchasing power by creating money out of thin air!

Very different world, of course, than the Bretton Woods agreement, which was anchored by something “real”: America’s commitment to exchange one ounce of gold for 35 dollars, while everybody else fixed their currencies to the dollar. In the early years of Bretton Woods, the world’s greatest concern was that America would not “export” enough dollars – i.e., run a sufficiently large current account deficit! This problem became known as the Triffin Dilemma – the thesis that the Bretton Woods system was inherently flawed, in that it would beget either (1) a chronic shortage of dollars if America ran a balanced trade account, or (2) a global surplus of dollars relative to America’s stock of gold if America ran chronic trade deficits.

Professor Triffin’s thesis was proven right, of course, as America did indeed run chronic trade deficits, creating a global glut of dollars relative to Uncle Sam’s stock of gold, necessitating other countries – notably France, but also Japan – to buy massive amounts of dollars, so as to maintain their pegged currencies versus the dollar. When, fearing the domestic inflationary consequences, these countries (notably France) tired of doing this, they asked America to honor its commitment to exchange gold for the dollars that they did not want. America refused and the Bretton Woods arrangement died: America closed the gold window and two years later, after repeated attempts to make work the unworkable pegged system, the (developed) world moved to a floating exchange rate regime.

But not a pure float. Rather, after Bretton Woods, the world adopted a managed floating regime, sometimes called a dirty float. Contrary to many observers, including presumably Secretary Snow, I see nothing wrong with dirty-floating exchange rates, rather than putatively pure, market-driven exchange rates. In a fiat currency world, markets themselves are hostage to the ways and means of sovereigns with printing presses. Money is what sovereigns say it is, unlike the case of Bretton Woods (and previous gold-backed currency regimes). Accordingly, the concept of pure market-determined exchange rates becomes an intellectual oxymoron when sovereigns own printing presses and get their ink (rather than gold!) for free.

Free Dumb to Choose

Dirty floating, as opposed to either mechanical adherence to pegged exchange rates or pure floating, represents the enlightened exercise of national sovergnity. Indeed, a measure of the maturity of a country is the freedom to determine its own monetary policy, in pursuit of its own best, national interest. And that includes a sovereign decision to be mercantilist, if such a paradigm pleases the national personality.

Mercantilism does reign in much of Asia, with high domestic saving rates, huge foreign exchange reserves, undervalued currencies on a purchasing power-parity basis, and large current account surpluses. Speaking as an American, this combination would not be pleasing to me, as it makes consumption an after thought in the pursuit of ever-greater stores of international wealth. Americans operate on the thesis that hearses don’t come with U-Haul trailers and spend accordingly.

Neither the Asian model nor the Anglo Saxon model is inherently right or wrong. Peoples’ utility functions are not homogenous: different strokes for different folks. And because peoples’ utility functions are different, there is scope for win-win international trade.

Except, of course, in the delicate matter of citizenship. There is no free market in passports. Indeed, the very definition of the sovereignty of nations includes the right – at the point of a gun – to define who is and isn’t a citizen: entitled to vote; subject to laws of the land, including the obligation to pay taxes and submit to conscription; and eligible for the social safety net funded by fellow citizens.

Accordingly, the leaders of sovereign countries rationally respond to exigencies beyond the economic doctrine of comparative advantage through free trade. This is nowhere more clear than in considering the political hot button of today called “outsourcing” – the creative destruction of American jobs in the (capitalist!) pursuit of profits through lower labor costs beyond America’s borders. Every sensible economist agrees that in the long run, “outsourcing” is a winning trade for both America and the countries who are the beneficiaries of outsourcing: American consumers get to buy more for less, and foreign workers get to move up the value-added chain, increasing their prosperity, too.

The problem is that the economist’s long-run dream is the politician’s short-term nightmare. Voters who benefit from free trade – employed consumers – do not reward politicians with yea votes, but those whose jobs are creatively destructed do punish politicians with nay votes. Thus, politicians are rationally less enthusiastic about free trade than economists. 1 This is particularly the case in times of weak global aggregate demand growth, which begets “beggar thy neighbor” pathologies: political leaders rationally want to get re-elected !   

In fact, I worry as much about America’s willingness to continue running a current account deficit as I do about the rest of the world’s continued willingness to fund America’s current account deficit. Indeed, I suspect that American citizens’ tolerance for exporting jobs is probably more shaky than other countries’ citizens appetite for sending their savings to America.

Fortunately, America’s political penchant for protectionism is, for the moment, of a macro nature rather than a micro nature: a lower dollar, which theoretically lifts all import prices, rather than sector-specific tariffs. Rather than triggering tit-for-tat tariffs on American exports (ghosts of Smoot Hawley!), America’s weak dollar is likely to trigger monetary and/or fiscal easing by other countries, to temper the deflationary effect of rising currencies on their aggregate demand. Accordingly, I believe strongly that America’s current account deficit, while ultimately unsustainable, can in fact be sustained for an extended period (which is much, much longer than a considerable period!).

Bottom Line

What the world needs is a dollar so low that it has no place to go but up, which would reenergize foreign private sector appetite for dollar-denominated assets. Such a lower level for the dollar would, of course, be negative for U.S. consumers – hiking import prices while restoring some degree of pricing power to American producers in their home market. But such a further fall in the dollar need not be a crisis, so long as appreciating non-dollar currencies are more painful to the rest of the world than a falling dollar is for the United States.

With the world having won the war against inflation commenced in 1979 by General Paul Volcker, a falling dollar is not presently a global inflationary problem, but rather a threat to the peace of global price stability. A falling dollar is a deflationary problem for other countries, which begs for a reflationary response. In contrast, a falling dollar would be a problem for America if, and only if , (1) America had an inflationary problem and/or (2) the Fed thought America had an inflationary problem, regardless of whether it did or not. Neither of these conditions holds.

In the fullness of time, these conditions might hold, in which case the unsustainably large current account deficit will, in fact, prove unsustainable. But between here and there, the unsustainable will be sustained. Indeed, no less an eminence than Alan Greenspan worries even less than I do about the intermediate-term sustainability of America’s unsustainable current account deficit.

While I believe that foreign central banks – operating in their countries’ own mercantilist best interests – will happily buy dollars when private sector investors don’t want them, Mr. Greenspan is even more sanguine than I am about the consequences if I’m wrong. Foreign central banks have printing presses, but Mr. Greenspan has got one, too, he reminded us. And if they don’t want to use theirs, he’s willing to use his!

Well, he didn’t exactly put it that way, but pretty darn close, when he declared last Friday night:

“With respect to the question (of) large holdings of U.S. Treasuries, which both the Chinese Central Bank and Japanese Ministry of Finance have accumulated, in an endeavor to suppress rises in their currencies: at some point one must presume that they will stop doing that, and perhaps even start to sell. The notion that that’s going to have a significant impact on the American interest rates I think (is) a little overdone in that central banks – indeed all reserves by official monetary authorities – tend to be short-term maturities. They have to have it for liquidity purposes.

And as you know, the short-term maturity market in dollars is huge, and at least for a time, it’s locked into the federal funds rate that we at the Fed initiate. I’m not saying that we could keep that locked in and that it wouldn’t matter no matter how much goes in (foreign central banks sell), but it’s not going to have an immediate effect largely because the size of both the private instruments and governing instruments in the short end of the market is huge, and it would take a great deal to have made a difference.

I’m not saying there will be zero effect, there will be some effect, there almost has to be some effect. But those who are concerned that the effects are large, because they are thinking of the long-term 30-year bonds, or even 10-year notes being sold in huge volume into the market having a negative effect: that’s not what we are dealing with.”

America is not begging for foreigners’ savings; rather, foreigners are begging America to take their savings as de facto vendor financing for their goods and services. This is certainly not the best outcome for the global economy but, in my view, the shame of it all is not that America is putatively consuming too much, but that the rest of the world is manifestly consuming less than it could or should.  

Brother Keynes saw the problem in 1936 and his doxology to free trade and aggregate demand
policies supportive of maximum employment in all countries is as relevant today as it was then:

“It is the policy of an autonomous rate of interest, unimpeded by international preoccupations, and of a national investment program directed to an optimum level of domestic employment which is twice blessed in the sense that it helps ourselves and our neighbors at the same time. And it is the simultaneous pursuit of these policies by all countries together which is capable of restoring economic health and strength internationally, whether we measure it by the level of domestic employment or by the volume of international trade.”

Paul McCulley
Managing Director
March 2, 2004

1" Our Currency, But Your Problem," Fed Focus, October 2003


This article contains the current opinions of the manager and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article is distributed for educational purposes only. Information contained herein has been obtained from sources believed reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission. ©2004, Pacific Investment Management Company LLC.