Tag Archive for 'Setser'

On China

Menzie Chinn emphasises that for the purposes of estimating country shares in global GDP, it is necessary to think of them in nominal terms.  On that basis, China is large, but only half the size of the Euro zone and well under half the size of America.  Therefore, he implies, an increase in demand from China won’t really contribute as much to global growth as people might be hoping.

Nevertheless, people do seem to be wondering about China as an engine of global growth in demand.  The reason is simple:  Despite a near catastrophic collapse in world trade, China’s economy is still growing while those of  other export-oriented countries like Japan or Germany are falling precipitously.

Clearly part of the reason for the continued Chinese growth, like in Australia, is the successful use of a fiscal stimulus to boost local demand (the Australian rebound was also helped by the fact that, by not manufacturing much, their decline in investment was offset by a fall in imports and (price) changes in natural resource exports occur with a significant lag).

Brad Setser has explored the Chinese stimulus a little.  He writes:

I initially underestimated the magnitude of China’s stimulus by focusing on the (fairly modest) change in the government’s fiscal balance. It is now clear that the majority of China’s stimulus has been off-budget: the huge increase in lending by state owned banks mattered far more than the change in the budget of the central government. The expected loss on these loans can be considered a form of fiscal stimulus.

Which is a fascinating way to conduct government business.

Is America recapitalising all the non-American banks?

The recent naming of the AIG counterparties [press release, NY Times coverage] reminded me of something and this post by Brad Setser has inspired me to write on it.

Back in January, I wrote a post that contained some mistakes.  I argued that part of the reason that the M1 money multiplier in America fell below unity was because foreign banks with branches in America and American banks with branches in other countries were taking deposits from other countries and placing them in (excess) reserve at the Federal Reserve.

My first mistake was in believing that that was the only reason why the multiplier fell below one.  Of course, even if the United States were in a state of autarky it could still fall below one as all it requires is that banks withdraw from investments outside the standard definitions of money and place the proceeds in their reserve account at the Fed.

And that was certainly happening, because by paying interest on excess reserves, the Fed placed a floor under the risk-adjusted return that banks would insist on receiving for any investment.  Any position with a risk-free-equivalent yield that was less than what the Fed was paying was very rapidly unwound.

Nevertheless, I believe that my idea still applies in part.  By paying interest on excess reserves, the Fed (surely?) also placed a floor under the risk-adjusted returns for anybody with access to a US depository institution, including foreign branches of US banks and foreign banks with branches in America.  The only difference is that those groups would also have had exchange-rate risk to incorporate.  But since the US dollar enjoys reserve currency status, it may have seemed a safe bet to assume that the USD would not fall while the money was in America at the Fed because of the global flight to quality.

The obvious question is to then ask how much money held in (excess) reserve at the Fed originated from outside of America.  Over 2008:Q4, the relevant movements were: [1]

Remember that, roughly speaking, the definitions are:

  • monetary base = currency + required reserves + excess reserves
  • m1 = currency + demand deposits

So we can infer that next to the $707 billion increase in excess reserves, demand deposits only increased by $148 billion and required reserves by $7 billion.

In a second mistake in my January post, I thought that it was the difference in growth between m1 and the monetary base that needed explaining.  That was silly.  Strictly speaking it is the entirety of the excess reserve growth that we want to explain.  How much was from US banks unwinding domestic positions and how much was from foreigners?

Which is where we get to Brad’s post.  In looking at the latest Flow of Funds data from the Federal Reserve, he noted with some puzzlement that over 2008:Q4 for the entire US banking system (see page 69 of the full pdf):

  • liabilities to domestic banks (floats and discrepancies in interbank transactions) went from $-50.9 billion to $-293.4 billion.
  • liabilities to foreign banks went from $-48.1 billion to $289.5 billion

I’m not sure about the first of those, but on the second that represents a net loan of $337.6 billion from foreign banks to US banks over that last quarter.

Could that be foreign banks indirectly making use of the Fed’s interest payments on excess reserves?

No matter what the extent of foreign banks putting money in reserve with the Fed, that process – together with the US government-backed settlements of AIGs foolish CDS contracts – amounts to America (partially) recapitalising not just its own, but the banking systems of the rest of the world too.

[1] M1 averaged 1435.1 in September and 1624.7 in December.  Monetary base averaged 936.138 in September and 1692.511 in December.  Currency averaged 776.7 in September and 819.0 in December. Excess reserves averaged 60.051 in September and 767.412 in December.  Remember that the monthly figures released by the Federal Reserve are dated at the 1st of the month but are actually an average for the whole of the month.

The velocity of money and the credit crisis

This is another one for my students of EC102.

Possibly the simplest model of aggregate demand in an economy is this equation:


The right-hand side is the nominal value of demand, being the price level multiplied by the real level of demand.  The left-hand side has the stock of money multiplied by the velocity of money, which is the number of times the average dollar (or pound, or euro) goes around the economy in a given time span.  The equation isn’t anything profound.  It’s an accounting identity that is always true, because V is constructed in order to make it hold.

The Quantity Theory of Money (QTM) builds on that equation.  The QTM assumes that V and Y are constant (or at least don’t respond to changes in M) and observes that, therefore, any change in M must only cause a corresponding change in P.  That is, an increase in the money supply will only result in inflation.

A corresponding idea is that of Money Neutrality.  If money is neutral, then changes in the money supply do not have any effect on real variables.  In this case, that means that a change in M does not cause a change in Y.  In other words, the neutrality of money is a necessary, but not sufficient condition for the QTM to hold; you also need the velocity of money to not vary with the money supply.

After years of research and arguing, economists generally agree today that money neutrality does not hold in the short run (i.e. in the short run, increasing the money supply does increase aggregate demand), but that it probably does hold in the long run (i.e. any such change in aggregate demand will only be temporary).

The velocity of money is an interesting concept, but it’s fiendishly difficult to tie down.

  • In the long-run, it has a secular upward trend (which is why the QTM doesn’t hold in the long run, even if money neutrality does).
  • It is extremely volatile in the short-run.
  • Since it is constructed rather than measured, it is a residual in the same way that Total Factor Productivity is a residual.  It is therefore a holding place for any measurement error in the other three variables.  This will be part, if not a large part, of the reason why it is so volatile in the short-run.
  • Nevertheless, the long run increases are pretty clearly real (i.e. not a statistical anomaly). We assume that this a result of improvements in technology.
  • Conceptually, a large value for V is representative of an efficient financial sector. More accurately, a large V is contingent on an efficient turn-around of money by the financial sector – if a new deposit doesn’t go out to a new loan very quickly, the velocity of money is low. The technology improvements I mentioned in the previous point are thus technologies specific to improving the efficiency of the finance industry.
  • As you might imagine, the velocity of money is also critically dependent on confidence both within and regarding banks.
  • Finally, the velocity of money is also related to the concept of fractional reserve banking, since we’re talking about how much money gets passed on via the banks for any given deposit.  In essence, the velocity of money must be positively related to the money multiplier.

Those last few points then feed us into the credit crisis and the recession we’re all now suffering through.

It’s fairly common for some people to blame the crisis on a global savings glut, especially after Ben Bernanke himself mentioned it back in 2005.  But, as Brad Setser says, “the debtor and the creditor tend to share responsibility for most financial crises. One borrows too much, the other lends too much.”

So while large savings in East-Asian and oil-producing countries may have been a push, we can use the idea of the velocity of money to think about the pull:

  1. There was some genuine innovation in the financial sector, which would have increased V even without any change in attitudes.
  2. Partially in response to that innovation, partially because of a belief that thanks to enlightened monetary policy aggregate uncertainty was reduced and, I believe, partially buoyed by the broader sense of victory of capitalism over communism following the fall of the Soviet Union, confidence both within and regarding the financial industry also rose.
  3. Both of those served to increase the velocity of money and, with it, real aggregate demand even in the absence of any especially loose monetary policy.
  4. Unfortunately, that increase in confidence was excessive, meaning that the increases in demand were excessive.
  5. Now, confidence both within and, in particular, regarding the banking sector has collapsed.  The result is a fall in the velocity of money (for any given deposit received, a bank is less likely to make a loan) and consequently, aggregate demand suffers.

Hot money and China

Brad Setser (there are lots of pretty graphs on his site):

There is only one way to square a record trade surplus with the sharp fall in reserve growth:

Hot money is now flowing out of China. Here is one way of thinking of it:

The trade surplus should have produced a $115 billion increase in China’s foreign assets. FDI inflows and interest income should combine to produce another $30-40 billion. The fall in the reserve requirement should have added another $50-55 billion (if not more) to China’s reserves. Sum it up and China’s reserves would have increased by about $200 billion in the absence of hot money flows. Instead they went up by about $50 billion. That implies that money is now flowing out of China as fast as it flowed in during the first part of 2008.

And in December, the outflows were absolutely brutal. December reserves were up by $20 billion or so after accounting for valuation changes – but the fall in the reserve requirement alone should have pushed reserves up by at least $25 billion. Throw in a close to $40 billion trade surplus and another $10 billion or so from FDI and interest income, and the small increases in reserves implies $70 billion plus in monthly hot only outflows … That’s huge. Annualized, it is well in excess of 10% of China’s GDP. Probably above 15%.

The mystery being, of course, who is doing the “hot money” transfers.  Chinese companies?  Investors from Taiwan or Hong Kong?  Investors from further abroad? Brad seems to suspect the second:

Over time, if hot money outflows subside, China’s reserve growth should converge to its current account surplus (plus net FDI inflows). That implies ongoing Treasury purchases – though not at the current pace – barring a shift back into “risk” assets. And if hot money outflows continue, watch for Hong Kong and Taiwan to buy more Treasuries. The money flowing out of China doesn’t just disappear … it has to go somewhere.