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Reinhart Squared: Is The US Too Big To Fail? (Must Read)
Originally posted on Voxeu.org
First posted 17 November 2008, this column's analysis is
more relevant than ever. It asks why investors rush to government
securities when the US was at the epicentre of the financial crisis?
This column attributes the paradox to key emerging market economies’
exchange practices, which require reserves most often invested in US
government securities. America’s exorbitant privilege comes with a cost
and a responsibility that US policy makers should bear in mind as they
address financial reform.
A
familiar script has played as the global financial crisis has spread,
picking up speed and intensity. The drama has three acts that have been
written out in the historical record for as long as there have been
open financial markets.
- Act One: Unbounded Enthusiasm. Some markets find favour with global investors.1 Credit becomes readily available, asset prices percolate, and many categories of spending are buoyed.
- Act Two: Day of Reckoning. Recognition that some of that enthusiasm
was overdone spreads among investors. New credit flows cease,
collateral is sought, asset prices crash, and prominent private-sector
icons crumble. - Act Three: Restoration. Here governments pick up the pieces,
typically passing on the cost to future generations by issuing a vast
volume of debt. The cost can be punishing because investors pull away
from the governments of emerging market economies as forcefully as they
do from private creditors.2
American exceptionalism
But there has been one prominent exception to this classic tale.
With fitting irony, the US, which is the epicentre of the crisis, has
avoided Act Three. The US enjoyed a capital inflow bonanza that funded
yawning current account deficits, and asset prices spiralled upward
only to crash. While the crash has constricted credit and is redrawing
the financial landscape, the US has not been punished by investors in
typical Act-Three fashion.
If this had happened to any other government in the world whose
national financial institutions were in as deep disarray as those of
the US, investors would have run for the hills – cutting off the
offending nation from global capital markets. But for the US, just the
opposite has happened.
Rather than facing prohibitive costs of raising funds, US Treasury Bills have seen yields fall in
absolute terms and markedly in relative terms to the yields on private
instruments. This has been called a “flight to safety”.3 But why do global investors rush into a burning building at the first sign of smoke?
The answer lies in part with the exchange market practices of key emerging market economies.
Since the last global market panic, the Asian Financial Crisis of
1998, many governments have stockpiled dollars in their attempts to
prevent their exchange rates from appreciating. At the same time, the
long upsurge in commodity prices has swollen the coffers of many
resource-rich nations. As a result, and as shown in the latest forecast
in the World Economic Outlook of the International Monetary Fund,
international reserves of emerging market economies are expected to
have increased $3.25 trillion in the last three years. According to the
Fund’s survey of the currency composition of those holdings, the bulk
is in dollars (see Figure 1).
Figure 1
The dollar portion of these reserves is most often invested in US
government securities, which offers excellent market liquidity, and US
government debt is also considered as safe as anything (following a
precedent laid down by the first Secretary of the Treasury, Alexander
Hamilton).4
All this explains the dollar’s popularity with foreign investors who
might otherwise be expected to shun the US. As the Figure 2 indicates,
foreign official entities now own almost one-quarter of outstanding
government securities (the upper panel). These holdings of securities
constitute about 10% of non-US nominal GDP (the lower panel).
Our currency, your problem
Herein lies the special status of US government securities. For a
few of the world’s key decision makers, it is not in their economic
interest to stop, or even slow, the purchase of Treasury Bills. As
Keynes once said: “If you owe your bank a hundred pounds, you have a
problem. But if you owe a million, the bank has a problem.” Potential
capital losses on existing stocks keep foreign investors locked into US
government securities.
Figure 2
Figure 2 also shows a precedent for recent financial market strains.
The last time foreign official purchases bulked so large in the US
government’s financing was from 1968 to 1973, when the Bretton Woods
system of managed exchange rates broke down.5
At that time, keeping the system going required increasing support from
abroad, primarily from Europe. This time around, the source of that
support has shifted to Asian-Pacific economies and Middle East
exporters. In both cases, the message from the US seems best summarised
in the words of then-Treasury-Secretary John Connolly, who famously
advised, “the dollar is our currency, but your problem.”
As the tone of those words suggests, another lesson from the earlier
experience is that foreign resentment with a US-dominated arrangement
grows over time. That America could be a source of financial
instability and a haven of sovereign financial security seems to some,
to quote Valerie Giscard d'Estaing, to be an “exorbitant privilege.”
In this episode, Treasury yields have fallen and the foreign exchange
value of the dollar has appreciated recently. Moreover, many European
financial firms have had funding difficulties associated with a lack of
access to dollar liquidity. This has made it necessary for European
officials, caps in hands, to seek swap arrangements with the Federal
Reserve to acquire dollars to re-lend to their national champions.
Recent enthusiasm in Europe for fundamental reform of the
international monetary system finds its roots, in part, in this
resentment. They do not want our dollar to be their problem, and they
want to erode some of that privilege. Put it those terms, however, it
seems clear that this will mostly be a one-way conversation. US
officials must recognise that their nation’s funding advantage rests on
the unrivalled, for now, position of US government securities in global
financial markets. Thus, they will listen and agree to work-streams for
groups to report back in the future. But whether it is this
Administration or the next, advantages to the US, unfair as that may
seem as viewed from abroad, will seem worth preserving.
An exorbitant privilege that comes with a cost and a responsibility
These advantages come with a cost and a responsibility. Open access
to markets probably allowed US officials to drift in their response to
the financial crisis. They initially mistook a solvency problem for a
liquidity one. When action was ultimately forthcoming, Treasury
officials failed to articulate a clear sense of principles and
priorities for intervention. This ad hoc improvisation has probably
stretched out and intensified the crisis. In a crisis in an emerging
market economy, the sudden stop of credit to the government forces
painful adjustment to be done quickly.6 These adjustments may have been painful, but a quick response tends to reduce the overall bail-out cost.
As for responsibility, officials must recognise that investors have
granted the US its reserve-currency status for reasons. Size matters,
but other reasons include a respect for the rule of law and for
contract enforcement and the predictability and transparency of the
policy process.
When US officials move to the next stage of the crisis – the search
for legislative protections to prevent a recurrence – it will be
important to preserve these attractive aspects of US markets.
References
Michael P. Dooley , David Folkerts-Landau, Peter Garber, “The revived Bretton Woods system,” International Journal of Finance & Economics Volume 9 Issue 4, 2004, pp. 307 – 313.
Reinhart, Carmen and Vincent Reinhart “Capital Flow Bonanzas: Past and
Present,” (with Vincent R. Reinhart) in Jeffrey Frankel and Francesco
Giavazzi (eds.) NBER International Seminar in Macroeconomics 2008, (Chicago: Chicago University Press for NBER, forthcoming 2008a).
Reinhart, Carmen and Vincent Reinhart, “From capital flow bonanza to financial crash,” VoxEU (2008b).
Reinhart, Carmen and Kenneth Rogoff, “The Forgotten History of Domestic Debt,” NBER Working Paper 13946, April 2008.
1 In Reinhart and Reinhart (2008a and b), we refer to this act as a “capital flow bonanza.”
2 Such funding strains have frequently been
sufficient to compel governments to default. This is why we find in
Reinhart and Reinhart (2008a) that episodes of capital flow bonanzas
help to predict sovereign defaults.
3 Following market practice and legal convention,
government securities include those of the US Treasury and the
government-sponsored enterprises.
4 The history of US debt is not unblemished. Reinhart
and Rogoff (2008) report that the US never defaulted on its sovereign
external debt but that the abrogation of the gold clause in 1934
constituted a domestic default.
5 Dooley, Folkerts-Landau, and Garber (2004) have
dubbed this latest period Bretton Woods II, in part exactly because of
the role of foreign official purchases in facilitating US current
account deficits. They pose plausible reasons why it might be in the
self-interest of foreign officials to do so. Another possibility, as
discussed earlier, is that existing portfolio holdings are so large
that officials are in a self-fulfilling trap.
6 In this regard, the current US situation is more
akin to that in Japan in the 1990s, when policymakers delayed
addressing the fundamental problem of non-performing loans and favoured
half-measures for some time. The Japanese government could tap a large
pool of domestic saving to fund its equivocations so that the opinion
of global creditors was not relevant. The lesson is market discipline
does not apply either if a nation is too big to fail or saves too much
to care.
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No.
Answer to why not:
Global economic, political, cultural, language superstate.
Our currency .. you're problem? This is a typical liberal-globalist BS view. America has lost it's cultural core and industrial base , now a bankrupt hated nation... for what!!!
To be fair, the man did not make up the sentence.
It is a quote without attribution.
Man who crafted the sentence is John Connally. Liberal? Conservative? Useless as anyone is ready to argue over that, just pure partisan bickering. Most stringent point is he is (or was) a US citizen.
As for responsibility, officials must recognise that investors have granted the US its reserve-currency status for reasons. Size matters, but other reasons include a respect for the rule of law and for contract enforcement and the predictability and transparency of the policy process.
ROFLOL. Puh-leeze -- gimme a break. As if investors had a choice, NOT. And the number one priority of U.S. foreign policy is to keep it that way. Just ask our oleaginous allies in the Gulf whether they still whisper about pricing their exports in anything other than Uncle Sam's paper. Not after 2003 they don't: "shock and awe" = "Mission Accomplished." You better believe it.
Oil Bitchez.
Oil.
We are knocking up against the limitz of the pertri dish, and our military will not be able to dish it out any more.
+1 Laughable.
Global kleptocrats + protection racket.
Isn't it interesting that America's enemies ([recent] past, present and I'm sure future) are those who have publicly declared they want(ed) to sell their exports (usually oil) in something other than dollars?
Let's call it coincidence theory because that's what the powers that be would have us believe. I stopped believing in coincidences when I discovered (smelled actually) that Santa Claus and the Easter Bunny wore the same after shave lotion. Bummer. And Old Spice at that, just like Daddy. What a coincidence.
I think you are on to something there CD. When did McCain start singing "Bomb-Bomb-Bomb, Bomb-bomb Iran"?...
Wasn't the most recent talk about a Middle Eastern petro-currency just a couple of years ago? It's probably a non-runner for precisely the boring reasons mentioned by the Rogoffs.
The world is already building tributaries around the diseased system in the form of bilateral arrangements, stockpiles etc. While small its a ball in motion and no amount of shock and awe barring a self mutilating barrage of rate hikes retards it.
Collateral Circulation in the macro-economic sense. I like that.
http://www.americanheart.org/presenter.jhtml?identifier=4583
"I'm all in. " Said BS as he slid two stacks across the felt. He looked up from the pot conditionally, with his usual blank stare. The game had started with BS raising X5. Europe raised them, and China called. Africa folded as they would wait to play their small stack on the next hand in hopes someone would drop out of the tourney. The Middle East then folded from the button, and Russia folded the small blind. The big blind was South America, and they folded, as they, like Africa, wanted to see if anyone would be eliminated. After a considerable time, BS made his move. "I am all in." It was now up to Europe to call or fold. Grease burned; Merkle waited and Sarkozy yelled. The rest of the Euro Zone countries snooped around or were to drunk too care. Claude Trichet fiddled with his chips and murmured to himself. If he called, it would commit most of his chips; he was quite certain China would call. Whoever wins would have a commanding lead over the Middle East and would be the prominent big stack. If China wins, it would pit Europe alongside the US in a side pot, and if the US won it would be all for the Euros, if not the doelarr. If Trichet had the cards to win it all, Europe could wait for another player to go all in in the remaining hands, and command the game.
BS was happy with his move. His time playing had grown on him, and he liked his cards; if the Hollywood Futures Index could play was the kicker, and if YALE's Facebook being made public hit, his virtual currentsea could fuse with the DOELARR CARD, if it showed up. This all before the flop.
Claude Trichet, do you call?
....we find out this week.
Nice gambling analogy. Congratulations.
Uh, no don't think so ... it is abundantly clear that Euroland was sunk from the get go, except for swaps, smoke and mirrors, and a 3 card monte game in the back room, their circus could never had gotten off the ground. And with the Club Med bunch livin' "La Vida Loco", it has always been just a question of when, not if the whole carny/gypsy inspired road show disintergrate.
So hell yeah, they resent it. The Euro is their problem.
Good luck with that.
even if the US fails and goes into chapter 7, it will still be worth a few bucks.
Maybe Ebay should create a new secton for all the american activa.
All bids start at 1$ with no reserve!
From a purely operational standpoint, the U.S. WILL NEVER unintentionally default on its debt. Remember, we live under a regime of fiat currency. Our dollars are not tied to any commoditized standard, such as gold. Dollars are simply digits on computers, and the Federal Reserve and the Treasury have the ability to add and take away zeros and ones from reserve accounts at will. The trillion or so dollars of U.S. debt that China holds is simply an interest-bearing account at The Fed. If China decided to 'cash in their U.S. chips' so to speak, all that would occur---operationally---is that those trillion dollars would be moved from an interest-bearing account to
a spending account at the Fed. We wouldn't be sending a trillion dollars worth of gold, or greenbacks, or whatever, over to Beijing.
YES, I understand inflation...I'm just referring to bankruptcy, per se.
the usa is too big too save and quite frankly not worth it given the leaders we have.
The U.S. is definitely too big to fail.
The Inter-Galactic Monetary Fund will have no choice but to make good on our debts.
How do you not mention oil and military in that article. The biggest "cost" for exceptionalism is military costs. We weren't "granted" anything. We took it and set up systems to enforce it. The "contract enforcement" as "asset" of the USA is creeping more into the conversation as of late. You might also hear people on the other side talk about law as an instrument of suppression. It can be EITHER. If all contracts are enforced, without restructuring, the world as we knew it, ends. Creditors want contracts enforced. Debtors want them restructured. Creditors have a way of doing things for themselves short term that hurt themselves long term.
Fraud is underlying MANY of these contracts if not the system of banking contract itself. But, the remedy for fraud, in Greece's case, between your own political class and foreign bankers is not apparent. It's a fraud without remedy. I see people are taking to the streets. I'm not surprised. In the US case, the same fraud exists, however our politicians have a stronger hand.... if they use it, because we are the reserve currency. That makes U.S. politicians potentially the most powerful people in the world, per pound.
Greece is a contract enforcement battle where "the people" can't bring a case for contract fraud against their own leaders and foreign banks (GS). Banks want to have the "enforce contract" talk, sure. But, they don't want to have the "fraud in the contract" conversation or the "triggering a systemic depression through enforcement" conversation. That conversation is ours to have with politicians. It's necessary. The reserve currency leader COULD lead this conversation. But, strict "contract enforcement" is NOT the answer. In fact, the LAW itself makes provision for breach and restructuring even including public policy exceptions. The banks don't want to have THAT conversation.
The U.S. is actually laying a small legal foundation for the restructuring of contract. (a legal principal too) surprise, surprise (SEC v. Goldman, Moody's Wells notice, etc..). Now, it depends on 1) how far we're willing to go with this foundation, 2) how tough the political class is willing to get with the creditors. (and that may depend on how tough things get for the political class). Our reserve currency status and the Fed Reserves bailout actually gives the U.S. POLITICAL CLASS more leverage over foreign and domestic banks than we've ever had. They COULD broker a restructuring.
Kid me not.
So the more the US debt grows, the more it is the issue of other countries? What a revelation, what a revelation. Extorting the weak works! Nobody's figured that before.
It took 3000 years of advancement in the most and best culture in the world to draw that conclusion. Worth the price in human lifes, anyone has to admit.
I've seen the light, I am to become an enlightened, an illuminato.
Yes...
Save that, next time, this guy and this woman will come for responsibility, that scam that never existed.
Who knows? Because the hallmark of power is to be able to escape responsibility.
The US is powerful and will escape responsibility.
Investors did not put their money in the US because of respect of the rule of the law (the US has performed in non respect of rule of law) but because this is the safest move in an extortion environment. Put your money on the gang lord turf, that's the safest place.
The Dollar is a old lion, once with a heart wild and free, but then captured and collared and used to serve wicked men with their wicked ideals. Now this lion's service has run out. It's being pulled to the slaughter by its masters. It was once too usefull, too powerfull, to fail. But then they created a larger and fiercer beast. It's lying there, in a laboratory, on the cold stainless steel of the operating table, sewed together of lesser creatures, hooked up, waiting for the right spark to awaken it. Soon, you will answer only to the Amero.
Fighting for freedom only leaves you without power.
Whatever has a beggining, has also an end.
I've uploaded a weekly DOW chart.
http://www.zerohedge.com/forum/latest-market-outlook-0
http://stockmarket618.wordpress.com
Uh, 2008 this ain't. We didn't see everyone fly to the 'safety' of the USD on Thursday. Nope, we saw just enough suckers run to it to give those with a monad of saavy who hold trillions of FIAT yet another opportunity to head for the harder assets. Y'know, that shit that is actually worth something...
Heh, how is this bailout of the EUR, obviously by means of 'QE to infinity', supposed to 'strengthen' that fiat, anyway? On a long enough timeline, infinite QE is good for my precious. - Gollum
we have markets in real economies and a created currency to
settle sales and purchases at prices in that economy. too mundane
and common, so it is juiced with fiat insatiable interest and left
to "market makers" to create credit (uncontrolled and gamed by
fraud that collapses every 7 years or so). as in speculative bubbles,
always frothy with undecipherable fraud. oh my, how can this keep
occurring so regularly? and for what? i would guess ... treasure,
access to the treasury. lootee of last resort.
.
the "good" life, as in life is tough and hard and unfair, so ....look out !
for yourself and get some .... treasure.......call it speculation or gambling
or investing or what not. the "system", juiced. by "buy a politician" or something.
"three for a dollar", step right up.
.
but my point is the real economy markets are one thing. the financial
plays that relate to them, derived from or derivative to, are the material
of the bubbles. that something other... as in marketing of markets, and
the bubble "on" the market becomes it's own market. these bubbles or
derivative industries or fields then are presented as, or taken as, markets,
made markets. they are not indigenous to the real economy per se. they
are synthetic and they are not globally translatable. they are culture and
circumstance dependant, potentially nothing but fictions of cognition . so they
are extremely vulnerable and must suffer the elasticity of a bubble or collapse.
so think of the massive fraud and credit creation associated with the housing
bubble which corresponded with the bubble of the financial sector, going from
16pc to 40pc GDP over 20 years. bubblenomics where a business model, industry,
a made market manifest derived from credit out of thin air.. the global "story" ....
and then collapse. but ... in the name of reflation (refusal to recognize the
manifest facts, nature of the system, the truth of money creation as it relates
to markets, made markets and pricing and compensation in both) fraud is
embraced, bubble making elevated to an art form, a market unto itself.
it is taken as the economy!
in a way it is consistent in that it is all about hype, advertising, image, fashion
the "idea", impression, the psychology of human psychological satisfaction and
identity in a chaotic field of speculation. ie. insanity! this is bubblenomics,
or tulips, or whatever where the synthetic derivative "market" or bubble
mechanisms are mistaken for a real economic market. and they are and they
are effective during the expansion phase. during contraction, not so useful.
or course it is made possible because somewhere else value is being extracted
from some thing or someone who is either enslaved, eliminated or being
"compensated".
.
so we go to bailout the massive misallocations during contraction but for this
to be other than a mere raping of the taxpayer to enrich the already rich and
stupid, these bailouts (dilution/creation of currency as a transfer of debt
from the private losers made winners to the public losers) become necessary
to continue to deny the nature of the structures that emerge during bubble expansion.
denial of their "value" to the real economy. but these synthetic and variably
useless bubble emerged entities and their signature creations live on!
.
so why is act three avoided in the usa? to date, attempts at reflation. but
this is a short circuit that will fail as liquidity is not flowing to the roots, to
mix metaphors, but is evaporating in the froth of heated fraud. no trickle down.
also, infrastructure costs and asset deflation . bubble structure during contraction
becomes pretty useless and aging physical assets become worthless, clunkers.
upgrades become speculatively unaffordable, the optics get foggy, the moods
sour, the minds entrench and become obstacles to the thought process, politics
and special interests become paramount and the uncertainty drives "money",
notes representing little more than bubble fraud, back into their nest/womb,
the bond market. safety. empiric nesting theory. here poorly interpreted and
represented the idea of antal fekete. many apologies.
.
but, this will lead to collapse of the real economy too. it is the collapse of
the bubble and it's corollary currency/note. it is what happens when the
means of exchange or currency becomes it's own market and becomes
dislocated from the markets it was manifest to serve. or what happens
when fraud replaces real socio-economic dynamics manifest by people
who are conscious of the real world and man's place in it.
.
then again perhaps we need a billion bankers and their lifestyles to
support the levels of debt being created. more yachts, that will do it!
and more casinos to satisfy the entertainment needs of an aging population
brought up on gambling as a way of life.
.
with apologies from the porch, and with all my own regrets, too.
"spam artist", i like that, but not so much initially.
price discovery
extended correction
exhilarating process
verbal warning
fates calling
winter near
that is a good one.