Fed Watch: Follow the Money

Tim Duy syas if you want to understand what's going on in the economy, then "follow the money and see where it leads":

Follow the Money, by Tim Duy: 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 US 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 US 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.

Comments

[hari]

I think what this (think-piece from a log cabin) means is that theory and practice is way out of touch with global financial liquidy. And the reality, as I see it, is global liquidity chasing leverage commodity markets - for the moment - a very sustainable return on speculative *black gold* and food items.

[Ryberg]

Invest in farms or gold mines can be sustainable but speculation in commodities is not. That global liquidity has moved from investments that can produce tangible future products to "investments" that only produce financial profits or losses, should give us concern. It should also give us great concern that the source of this liquidity has not come from organic growth in the economy but from artificial stimulus caused by government deficits and debt growth. Note that total US debt is growing at a rate in excess of $3 trillion annually even though the real economy is stagnating. It is understandable that a growing volume of this liquidity sloshes into commodities driving up their prices, but it is also clear that this is not a sustainable arrangement.

[hari]

However the Futures Market in commodities is now, in fact, the only place with multiples which attract global liquidity as a result of cascading US dollar rate and low growth and global inflation. In the 1970s, we also had this combination of petro-dollar mountains and double digit inflation....

[JKH]

The point is that you can’t follow the specific trail of foreign money in an economy with a system of complex financial intermediation such as the US. It's a contradiction.

The textbook “differential equation” that net capital inflows finance excess investment is a selective tautology. It is just as correct to suggest that domestic income finances domestic investment and that net capital inflows finance the current account deficit.

This is all selective marginal asset-liability matching. It’s bad analysis. The same holds for attaching inflows to commodity speculation.

Foreign capital inflow is completely malleable with domestic capital insofar as where it ends up.

The larger distortion lies in the questionable notion of the “global savings glut”. The current account deficit is created mostly by the exchange of claims on domestic banks for imports. Foreign surplus nations move those bank claims around (FX market) and further exchange them for other types of claims (e.g. bonds). Required capital inflows are automatically forthcoming in the initial acceptance of those bank claims. It’s the subsequent portfolio allocation that sets the final profile and pricing of that “capital inflow”. Chinese purchases of Treasuries finance expenditures on imports every bit as much as they do “excess investment” in the domestic US. But neither is true in any meaningful way. Those treasuries represent a portfolio allocation of funds that have already financed the deficit as soon as China accepts Wal Mart’s domestic US bank draft as payment for China’s exports. Wal Mart customers likely started the financing china by borrowing from their US banks.

Subsequent “capital inflows” are a reallocation of this elementary exchange and hence a plug for financing that starts in the US. That’s how the housing boom fed related consumption demand into the deficit. The fact that a relatively small proportion of deficit financing ended up as mortgage related funding is really a post-deficit portfolio allocation prodded by US financial engineering supply more than foreign demand.

The economic analysis of current and capital account flows remains wishfully disconnected from the facts of the monetary flows. The whole thing is malleable, not separable.

[ken melvin]

Sorry about the loss of sleep Prof. Duy, but, eh, we've all been there. Thanks for writing this very good piece about this very important phenomenon.

[bakho]

One obvious place for investment to flow is alternative energy technology. World demand for energy and carbon reduction is clear. Efficiency improvements will have customers.

[bullbust]

The lesson I took away from this episode was to drop your preconceived ideas about what you were sure would happen

So now "ivory tower economist" is a given? Economists live in a world of models and preconceived ideas totally disconnected from reality?

Previously, anyone who wrote what Duy wrote in this one, would be called any number of names, ostracized, banished and ignored. Now that "respectable" economists are saying the same thing, its acceptable.

So economics is nothing but what a bunch of economists in power wants it to be. Pure thuggery.

[Winslow R]

Understand the current global crisis is a commodity crisis tied to monopoly power in the oil market and an unwillingness of the global participants to fairly allocate growth and reduce demand (though removal of fuel subsidies is a start). Just because China recently decided to become more capitalistic and is growing at 15%, they shouldn't expect other countries to slow growth to 0% in order to break the OPEC monopoly. All countries should work together to reduce demand and find alternatives sufficient to break the OPEC monopoly.

The best way to break the monopoly is through efficiency and substitution (but not into food based fuels). Government should make subsidized fixed rate loans at the current fed funds rate available for alternate renewable energy projects even once the OPEC monopoly is broken. Time to shrink oil producers down to a size where we can....................We cannot depend on investment by foreign SWF's to solve this problem.

[me]

Catherine Mann? Is that the same Catherine Mann that wrote a paper back in 2000 telling us how great outsourcing IT jobs to India was because it would create lots of IT jobs in the US? Thought so. Well, Catherine, IBM fired 50,000 US workers and didn't' hire any. I am not sure when you thought all those jobs would be created but there are less working in IT now than in 2000. Many of us are still waiting.

[Michael McKinlay]

Well , it is called capital destruction isn't it ....

Much of the money is evaporating because the credit behind it is being written off. It is called fractional reserve banking.

Ask the Saudis about their investment in Citibank ! Ask any recent investor about the money they invested in the stock market.

Huge amounts of money are just evaporating because of fractional reserve banking. For every dollar of writeoffs $10 of money and credit disappear.

[Inflation Hedge]

"That global liquidity has moved from investments that can produce tangible future products to "investments" that only produce financial profits or losses, should give us concern."

This actually happened quite some time ago. Global liquidity previously bid up the price of homes, which produce nothing. Now global liquidity is bidding up the price of alternative inflation hedges. Interest rates are being kept low by central banks buying each others' bonds, but the money creation needed to accomplish this is causing a lack of confidence in productive investments. Savers are frantically moving from one inflation hedge to another, in a desperate attempt to protect themselves.

What many people are missing is that while low inflation has little short term affect on savings vehicles, it definitely does have a very large long term effect. The US was ahead of the curve here, with savers switching almost entirely to inflation hedges. This leaves the US with no domestic savings in a form which can be loaned out. Now the rest of the world is slowly starting to follow the pattern.

Once savers' confidence in currency is lost, it can take a long time to restore.

[Michael McKinlay]

"Once savers' confidence in currency is lost"

It is that and much more. Our whole financial and tax structure makes saving a losing game. Capital gains taxes, non cash expense tax rules and leverage, cheap money and tax disincentives for savings make risk a must to preserve capital.

The leverage money creation out of the debt of fractional reserve banking cheapen money beyond productivity and population growth. We are in a Ponzi Scheme run by the banks and enshrined by politicians called ever increasing "growth" that is beginning to run afoul of the limits of the earth to provide material and support.

[Inflation Hedge]

You are correct, of course. Compounding the losses inflicted by inflation, taxes take away the already inadequate inflation adjust portion of interest/capital gains. With real interest rates already negative, taxes drive the real losses even higher. With the S&P showing substantial real losses this decade, taxes compound the losses.

If constant inflation is the policy, not exempting the inflation adjust portion of interest/capital gains from taxes discourages savings from moving into productive areas even faster. This is part of the reason the US is ahead of the curve with its negative savings rate.

[Motto]

The more there is of mine, the less there is of yours. This should be the motto of the money creators.

[Real Person from the Real World]

Mike McKinley above makes good points. What does a bank account pay now? 2%? special CDs that lock up your money for varying amounts of time pay more. However, what does a credit card company charge in interest payments? What about low salaries and things you have no choice about buying? Food, gasoline, car or roof repair? all expensive compared to many salaries. The car repair guy doesn't care that he is charging $90+/hr, while you make $20+/hr. He still wants his money. You invest in real estate lately? you get burned. You have money in mutual funds or stocks? you have capital gains taxes. Your piddly income on saving is also taxed.

But yes, we need to raise not cut taxes, BUT tax who, what, and where? Tax the CEO's pay and and keep the taxes on their capital gains and stock options lower, and they just change their pay structure to favor the latter.

Perhaps the compensation of so many of these exceptionally overpaid few is not actually based on exceptional performance as is claimed by so many justifying rock star salaries of some, but rather more towards being in the right job at the right time and wishes and perceptions of ability. True, some people can perform better than others, Mike Jordan was likable and a great basket ball player, but history is filled with lowly individuals that of their own, or when necessary or called upon, did extraordinary things. Sometimes religious non-conformists who were excluded from the establishment went into science or other areas less dependent on what you believed and where you came from, and they succeeded. Isn't that what many of the US founding fathers were? What about William Penn or Lord Baltimore?

I think we need to abandon the idea that some people are so superior to everyone else that they necessarily deserve immensely superior pay out of all proportion to everyone else. We need regulation to control the greed of the market place, and we need sensible development and retainment of jobs. We also need to recognize social good of education for as many as possible, and open access to medical care.

[wjd123]

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.--Tim Duy

This is very depressing. I wish Tim had gone to bed. Let me see if I have this right. There is a difference between unofficial and official investors. The unofficial type aren't willing to get 2% on their money if inflation is at 4%. Looking for a decent return the hot money flow of unofficial investors is now in commodities.

The official type would find driving up the price of commodities self defeating. They invest with a purpose which isn't always straight forward. For instance China's government was willing to invest in our Treasury bills because they wanted to bring down long term interest rates so Americans could tap the equity in their homes to have cash to spend which in turn would help keep the Chinese economy going and the Chinese people employed. It also wanted to keep the dollar from depreciating in order to keep the yuan from appreciating.

China succeeded in their purpose until the asset value of houses started to decline. With it and the machinations of financial institutions went growth here in America.

No growth means that unofficial investors will look for opportunities elsewhere. Meanwhile the only play left to China is to try to keep the dollar from depreciating against the yuan any faster than it is.

Central banks are left to decide if they want to raise rates which might take pressure off commodities but will deepen the housing problem or wait things out in the hopes that the unofficial types of investors will find something productive to invest in. Yikes!

[James]

"Hot money" seeks the highest short term returns, aka speculation, and today that is in the commodity market, which is gaining traction as a hedge against the falling dollar. Previously is was in the technology bubble, and then the US equity bubble reflation.

There has been a steady flow of money from overseas central banks as Brad Setser and others (myself included) have long estimated from various semi-opaque sources including the Custodial Accounts of the NY Fed.

As a side effect of this continual infusion of debt for GDP, we have been set up for a nasty stagflationary recession. It could be worse if panic causes a more precipitous impairment of money creation.

For those above who wave the flag of deflation, they need to ask themselves, 'what is money' and be a little more sophisticated in their thoughts about it. Writing off debt does not 'destroy money.' It does inhibit the creation of money to the extent that the US dollar and the Bond are able to support it. Think 'russia' and not 'japan.'

[Matt]

Tim - nice piece, having been involved in some sectoral rescue during the asian crisis I think your regional comments are very good.

For the current situation, along with follow the money is another theme: "follow the absence of money". What tha!? Seriously, there is an absence of liquidity and credit in significant numbers of US households; prime foreclosure rates are mirroring subprimes, but there frankly horrifying element is what's going to play out in terms of auto loan subprimes, and credit card debt. One of the most immoral lending practices I've ever observed involves the finest of fine print in credit card contracts, which, inter alia, suggest that if a cardholder defaults on a debt or routine payment other than the card, they'll rack up rates anyway on the grounds of universal default.

Not a pretty picture if one class of obligations is in arrears, and the others start to compound the problem. There's something basically wrong with this. Improvement suggestions on blog or back on envelope please...
M

[solicitor bulgaria]

What capital inflows for money exist? 1. Countries other then US. Could South Africans (or wherever) be remortgaging soon? 2. Technology. Could solar or some such become what the tech bubble of the late 90's was? 3. Countries governments. Could all that asian/mid east money go into infrastructure in africa? If so how many roads vs palaces would be built? 4. No inflows. Could the Asian/Mid east money go to Asians who then use it to buy things?