Friday, May 28, 2010

The World in Decession

. Friday, May 28, 2010

In The World in Depression, Charles Kindleberger argued that the hegemon must provide five public goods to the rest of the globe:

1. Purchaser of last resort for distress goods.
2. Lender of last resort for governments and provider of liquidity to the global system.
3. Maintain a stable system of exchange rates.
4. Ensure macroeconomic coordination.
5. Provider of countercyclical lending.

Arguably the U.S. has fulfilled #s 1, 2, & 4 pretty well, while #5 has been taken over by export-biased economies and #3 is less necessary in a system of flexible rates. But Brad DeLong argues that there is a sixth:

The hope is that, by Walras's Law which tells us that excess demands across all markets must sum to zero, that relieving excess demand for AAA assets will produce as a consequence the relief of excess supply and full-employment balance in the markets for goods, services, and labor as well. ...

[W]e are extremely far from cracking the U.S. government's status as the supplier of AAA assets to the global economy right now. When we see signs that further issues of Treasury bonds or loan guarantees by the U.S. government are starting to erode the AAA status of U.S. government debt, then will be the time to back off of expansionary U.S. fiscal, monetary, and banking policy. Then--not now.

This is similar to #2 in reverse: creating highly rated, largely liquid instruments when the demand for such assets outstrips supply, and selling them to soak up excess liquidity in the system. When might demand for AAA assets outstrip supply? I can think of two scenarios:

1. When there is a negative shock restricting the supply of AAA assets.
2. When financial markets are not functioning normally.

Obviously both of these have recently occurred. In the first case, many assets formerly thought to be safe and liquid -- Eurozone debt, mortgage-backed securities and other asset-back securities -- are no longer thought to be safe and liquid, so all of the money that was previously in those assets has to go somewhere; they have largely gone to U.S. Treasuries. In the second case, financial markets are still not functioning smoothly, so investors are still looking for quality. Right now, that means T-bills.

This is policymaking-in-crisis, of course; as financial markets normalize and other safe/liquid investments return to markets supply will meet demand, the price of Treasuries will drop (i.e. interest payments will rise), and the U.S. will need to pull back its expansionist domestic policies. But until that day, the U.S. is not only helping itself by spending in deficit. It is helping foreign investors (including governments) as well.


Emmanuel said...

You can't be serious--"deficits don't matter because the rest of the world demands them" is pretty novel, but...

1. The more conventional "exorbitant privilege" argument is that the ROW of the world is made to pick up America's tab.

2. This Amerocentric reasoning doesn't distinguish between different Eurozone debt issues. Last I checked, German bunds yielded even lower than Treasuries. So Germany should run even more massive American-style deficits, right?

3. Consider that financial markets will probably never "normalize" in the sense that developed countries will tend to run largish deficits from here on in because of demographic factors and corresponding health and pension obligations.

4. If US Treasuries are so safe, why on Earth would Geithner be regarded as a joke at an elite Chinese university?

Again, the best thing for the world to do is put the US econocomedians out of their misery as America is clearly out of control. This laughingstock act called America deserve its comeuppance--and I will explain how soon.

Kindred Winecoff said...

Admittedly I sound like I'm cheerleading here, but that wasn't my intention. I'm really trying to come to grips with why Treasuries haven't yet spiked, and DeLong's post made some sense: SWFs and institutional investors need large quantities of safe, liquid assets. ABS used to fulfill that role, but no longer. And since some Euro debt is so shaky, and the safer Euro countries are staying away from deficits, that basically leaves Treasuries.

That seems to explain demand and supply fairly well, and I was just trying to tie it into a broader political economy perspective. (I'm still thinking through how all of this might work, but I think it makes sense.) By this rationale and others Germany should *absolutely* be running bigger deficits.

Maybe America is out of control. Or maybe it's just responding to the incentives in front of it. Right now those incentives are to spend spend spend. Eventually that will change, but probably not tomorrow.

The World in Decession




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