Wednesday, September 3, 2014

11/21/2003 It's Here *

A faltering dollar, along with terrorism and trade concerns, weighed on global equity markets this week.  Here at home, stocks faced only moderate selling pressure.  For the week, the Dow and S&P500 declined better than 1%.  The Transports dropped 3% and the Morgan Stanley Cyclical index declined 2%.  The Utilities and Morgan Stanley Consumer indices lost about 1%.  The small cap Russell 2000 declined 1%, with the S&P400 Midcap index declining less than 2%.  The technology sector was under general selling pressure.  The NASDAQ100 declined 2%, the Morgan Stanley High Tech index 3%, and the Semiconductors 1%.  The Internet index dipped 3%, and the NASDAQ Telecom index declined 2%.  The Biotechs gave up 1%.  The financial stocks were mixed, with the Broker/Dealers hit for 3%, while the Banks declined less than 1%.  With bullion up $1.50, the HUI Gold index posted a 4% advance.

Treasuries benefited from a mild flight to quality.  For the week, 2-year Treasury yields were about unchanged to yield 1.81%.  Five-year yields declined 5 basis points to 3.14%, with 10-year yields sinking 6 basis points to 4.16%.  The long-bond saw its yield decline 5 basis points to 5.0%.  Fannie Mae benchmark mortgage-backed yields rose 1 basis point.  The spread on Fannie's 4 3/8% 2013 note widened 1 to 37.5, and the spread on Freddie’s 4 ½ 2013 note widened 1 to 36.5.  The 10-year dollar swap spread added 0.5 to 39.5.  Corporate spreads widened marginally.  The implied yield on December 2004 Eurodollars declined 3.5 basis points to 2.33%.  With the Fed aggressively signaling easy money for some time to come, the S&P Homebuilding index jumped 3% this week (2003 gains of 89%).

Bloomberg tallied almost $23 billion of corporate bond issuance this week, one of the strongest weeks of the year and the most in two months.  Wednesday’s corporate issuance of $9.2 billion was the biggest day since June 26.  Investment grade issuers included Ford Motor Credit $3 billion, Schering-Plough $2.4 billion, Procter & Gamble $1.2 billion, Credit Suisse USA $1 billion, ICI Wilmington $1 billion, Lehman Brothers $500 million, Kinder Morgan $500 million, Metlife $500 million, Union Planters $500 million, Capital One $500 million, Nexen $500 million, Protective Life $450 million, Harley Davidson $400 million (Harley CFO:  “We were about four times over-subscribed within 15 minutes of announcing the transaction.”), Florida Power $300 million, Medwestvaco $300 million, Transalta $300 million, Rockwell Collins $200 million, Vornado Realty $200 million, Potomac Electric $200 million, Columbus Southern Power $150 million, and Realty Income $150 million.   

Foreign issuers of dollar-denominated debt continue to revel in unprecedented global dollar liquidity.

November 18 – Bloomberg:  “Hutchison Whampoa Ltd., the holding company controlled by Hong Kong billionaire Li Ka-Shing, led borrowers in the U.S. with a sale of $5 billion of notes, the biggest global bond sale ever for an Asian company. The ports and telecommunications company boosted the amount after investors sought four times its initial offer of $3 billion… Hutchinson was joined by other foreign sellers today, including the Canadian province of Ontario and Australia and New Zealand Banking Group Ltd.”

Ontario Province this week sold $1 billion, ANZ Capital Trust $1.1 billion, Canada Mortgage and Housing $500 million, Braskem SA $275 million and Korea Gas $250 million.   

Junk bonds inflows rose to $306.3 million (from AMG). Year-to-date junk bond flows of $25 billion are easily a new record.  Junk issuers included Millicom Intl $550 million, Nortek $515 million, LNR Property $400 million, Royal Caribbean $350 million, Enersis $350 million, Crown Castle $300 million, Media News Group $300 million, General Cable $285 million, Equistar Chemical $250 million, OMI $200 million, Pinnacle Foods $200 million, J Ray McDermott $200 million, North American Energy $100 million, Millar Western $190 million, IMAX $160 million, Poster Financial $155 million, Georgia Gulf $100 million, and Thornburg Mortgage $55 million.    

It was a strong week for Convert issuance as well:  American Express $2.0 billion, Invitrogen $350 million, Yellow Corp $130 million, Millennium Chemical $125 million, Kulicke & Soffa $185 million, and LandAmerica $100 million.

Brazil’s central bank cut their overnight target rate 150 basis points to 17.5%, a two-year low.  The benchmark Brazilian “C bond” yield dropped 39 basis points this week to a new low yield of 9.01%.  It is worth noting that this yield is down almost 350 basis points since the July/August spike.  The Brazil Bovespa index closed today at a record high, with 2003 gains of 71%. 

Commodities Watch:

The CRB index took it on the chin this week, dropping almost 3%.  High-flying copper declined 6% and Cotton sank 7%.  Yet, and I would argue importantly, gold and crude oil held their own.  Additionally, the commodity currencies continue to shine.  The South African rand surged better than 3% this week, increasing y-t-d gains to 31%.  The Australian (up 29% y-t-d) and New Zealand (up 22% y-t-d) dollars traded to their highest respective levels since October 1997.  The Canadian dollar was about unchanged this week at a near 10-year high. 

November 20 – Associated Press:  “For the first time in six years, Chinese grain harvests are falling short of demand and reviving the question: Will China be forced to rely on imports to feed itself?  Since late summer, wheat prices in the northeast have shot up by 32 percent; corn prices have doubled and rice prices are up by as much as 13 percent, according to official reports. Prices of edible oil, vegetables, meat and other food products have also jumped.  Grain harvests this year are estimated to have fallen for the fifth year in a row -- hit by a double whammy of bad weather and cutbacks in acreage. ‘They’ve got a problem with their stocks and the crunch is hitting now, partly because of the weather,’ says Rich Herzfelder, executive vice president of the China Food and Agricultural Services, a Shanghai-based consultancy.”

November 18 – Bloomberg:  “Goldman Sachs Group Inc… raised price forecasts for metals such as aluminum and copper and iron ore because of economic growth in China.  ‘The risks to our new higher metal price forecasts are skewed to the upside… In contrast to the consensus view we would argue that Chinese metal demand is not a transient phenomenon.’”
November 17 – Bloomberg:  “A record U.S. corn harvest and rising demand in Europe and Asia for wheat and soybeans have created a shortage of railcars to transport the crops. The scarcity is slowing overseas sales for suppliers such as Cargill Inc. and raising costs for railroads like Union Pacific Corp. The monthly lease rate for a 120-ton ‘grain hopper’ railcar, capable of carrying 5,150 cubic feet of grain, is about $200 to $250, up from $120 to $150 a year ago…”

Global Reflation Watch:

November 18 – Bloomberg:  “Indonesia said it may almost double a planned sale of global bonds to $1 billion after investors showed interest in the nation's first overseas debt offering since 1996.  ‘The response was very positive,’ Bank Indonesia Governor Burhanuddin Abdullah said… Indonesia’s 7.75 percent bond maturing in August 2006 yields about 2.7 percentage points more than similar-maturity U.S. Treasuries…(having) narrowed from about 3.5 percentage points at the start of October.”

November 17 – Bloomberg:  “China’s economy may expand 8.7 percent this year and 9.5 percent next year, Goldman Sachs Group Inc. said in a report, which also raised growth estimates for Hong Kong, South Korea, Taiwan and Singapore. China’s gross domestic product was previously forecast to gain 8.1 percent in 2003 and 8.4 percent next year, the U.S. brokerage said in its research report published today… ‘China is still at an early stage of a new expansion cycle,’ the brokerage said. ‘An acceleration in China’s domestic demand will translate into stronger exports, which will in turn feed into a stronger pickup in fixed investment.”

November 17 – Bloomberg:  “China’s retail sales grew in October at their fastest pace in two years as rising incomes and a credit boom enable consumers to buy more cars, homes and cell phones. Sales in the world’s sixth-largest economy increased 10.2 percent from a year earlier… Goldman Sachs Group Inc. raised its 2004 growth forecasts for Singapore and Taiwan to 5.8 percent from 4.5 percent and 5 percent respectively, today’s research note showed. It also lifted its estimate for South Korea to 6 percent from 5 percent.  All three economies count China, including Hong Kong, as their No. 1 overseas market.  ‘China’s importance as an export market for the rest of Asia has taken a quantum leap since 2002,’ Goldman said today in a research note. ‘Asian exports have been revving up of late, again spurred by China.’”
November 20 – Bloomberg:  “U.K. retail sales last month rose twice as fast as expected and mortgage lending soared to a record, increasing the risk of a sharp slowdown in consumer spending later on, economists said…”
November 19 – Bloomberg:  “Russia’s economy will probably grow at the fastest pace since 2000 this year, the Economy Ministry said, as oil prices average $5 a barrel more than the highest government forecast and consumer spending soars. Gross domestic product will rise 6.6 percent this year, Deputy Economy Minister Arkady Dvorkovich told lawmakers in Moscow…”

November 19 – Bloomberg:  “Malaysia’s economy accelerated in the third quarter as computer chipmakers including Unisem (M) Bhd. and oil-palm producers such as United Plantations Bhd. raised production to meet increased demand from overseas. Gross domestic product expanded 5.1 percent in July to September from a year earlier, the central bank said, faster than the median forecast of 4.7 percent…” “Malaysia’s broadest measure of money in circulation rose in October at its fastest pace in more than five years, as exporters brought home money earned overseas and investment increased, the central bank said.”
Domestic Credit Inflation Watch:

November 21 – Bloomberg:  “Federal Reserve officials sent a message to financial markets this week: There is no need to raise interest rates to curb a U.S. economic recoveryIn eight speeches so far this week, and with another three to come today, the signal from policy makers is that the Fed will allow economic growth to strengthen without raising interest rates because there’s no danger of inflation.  ‘It’s very easy to conclude that the Fed is accommodative, and fairly significantly accommodative,’ Robert Parry, president of the Federal Reserve Bank of San Francisco, told Australian business economists… ‘We are comfortable with that position because of all of the slack we have in the labor and product markets,’ Parry said.

November 19 – Dow Jones:  “Assets under management in the hedge fund industry have rocketed to over $745 billion, according to a survey published by trade magazine Alternative Services Review Wednesday.  The figure is significantly higher than the $600 billion estimate generally given by industry commentators. ASFR’s figure only relates to funds that use a third-party administrator, so the total amount of existing hedge fund assets is probably higher, ASFR editor Angus Rodger told Dow Jones Newswires.”
November 19 – Bloomberg:  “The St. Louis Cardinals will begin construction on a new downtown ballpark by Dec. 31 after a state board Tuesday approved $45 million of tax-exempt bonds and $29 million of tax credits to help fund the stadium, the St. Louis Post-Dispatch reported.  The Cardinals plan to close on private financing of the $402 million project Dec. 18 and begin construction by year-end…”

Nov. 19 (Bloomberg) -- Robert E. Rubin, a former U.S. Treasury secretary and executive at Citigroup Inc., comments on Fannie Mae and Freddie Mac… ‘I think Fannie Mae and Freddie Mac serve a very useful purpose in terms of improving mortgage finance in this country, Rubin said.  ‘The problem is that they do have a number of real benefits including the implicit, not explicit, but implicit guarantee of the U.S. government. As long as they stay within their charter it seems to me they serve a very useful purpose.’ ‘There are two sets of issues. It is subsidized capital to some extent, and once they get outside of the area in which they were chartered to operate, the question is do you want to create that distortion in capital. I think that distortion is well-advised for the purpose they serve. Once you get outside of that you have to decide what purpose is that serving.  ‘On the question of whether it is a real risk to our system, I don’t profess expertise, but it seems to me that is an issue that is manageable.’”

Weekly (holiday-shortened) bankruptcy filings dropped to 27,891, with y-t-d filings running up 6.5%. 

Broad money (M3) supply declined $8.5 billion for the week ended November 10.  Demand and Checkable Deposits dropped $18.9 billion, while Savings Deposits jumped $36.1 billion.  Small Denominated Deposits dipped $2.4 billion and Retail Money Fund deposits declined $6.2 billion.  Institutional Money Fund Deposits dropped $17.1 billion, while Large Denominated Deposits added $7.8 billion.  Repurchase Agreements declined $8.7 billion, while Eurodollar deposits added $0.7 billion.  Over the past 11 weeks, Money Market Fund deposits (Retail and Institutional) have contracted $100.7 billion, or 23% annualized.  It is worth noting that Savings Deposits are up almost $29 billion over the past 11 weeks and have expanded at a 16.6% annualized rate year-to-date to $3.16 Trillion.

Total Commercial Paper declined $9.4 billion.  Financial CP dropped $9.8 billion and Non-financial added $0.4 billion.  Financial CP has declined almost $50 billion from July highs.  Total Bank Assets surged $88.2 billion.  Securities holdings jumped $7.9 billion.  Loans & Leases increased $15.6 billion ($32.6 billion over two weeks).  Commercial and Industrial loans increased $1.9 billion, Real Estate loans $1.1 billion, Consumer loans $4.0 billion, Security loans $4.1 billion and Other loans $4.7 billion.  Cash and Other Assets jumped $60.2 billion. 

Foreign “custody” Holdings of U.S. and Agency debt increased $11.9 billion last week.  Custody holdings have surged $92 billion, or 29% annualized, since the end of July (16 weeks).  Year-to-date, custody holdings are up $163.5 billion, or almost 22% annualized, to $1.01 Trillion.  Custody holdings are up 37% over the past 18 months (since May 8, 2002).

Freddie Mac posted 30-year fixed mortgage rates dropped 20 basis points this past week to 5.83% (lowest in seven weeks).  Fifteen-year fixed mortgage rates sank 22 basis points to 5.17%.  One-year adjustable rate mortgages could be had at 3.72%, down 4 basis points for the week.  The Mortgage Bankers Association Purchase index jumped 13.5% the past week to the highest level in five weeks.   Purchase applications were up 11.5% y-o-y, with dollar volume up 20.0%.  The ratio of adjustable-rate to total mortgages has jumped to 27.5%, the highest since early 2000.

October Housing Starts and Building permits data were nothing short of spectacular.  Housing Starts rose to the highest level since January 1986.  Year-over-year, Starts were up a blistering 17.6% to 1.96 million annualized, with Single-family Starts up 17.4% and Multi-family up 18.2%.  Building Permits were issued at an annualized rate of 1.973 million units, the strongest rate since 1984.   Permits were 9.7% above October 2002, with Single-family up 9.9% and Multi-family up 9.0%.  And to put some perspective into October’s almost 2 million annualized Housing Starts, it is worth noting that Starts declined to a low of 800,000 back in 1991 and did not surpass 1.6 million units until the second half of 1998.

November 19 – Los Angeles Times (Karen Robinson-Jacobs):  “Defying the usual fall slowdown, home sales last month in Los Angeles and Orange counties hit the highest level for any October since 1988… Sales of new and previously owned single-family houses and condominiums in Los Angeles County rose 13% from October 2002. Sales increased by 9% in Orange County, according to…DataQuick.  And November, usually one of the slowest sales months of the year, also appears to be shaping up to be a record buster.  ‘Our [third quarter] was up 48%, in terms of sales volume’ compared with 2002, said Peter Hernandez, president of Coldwell Banker Orange County. ‘And November looks stronger than October.’  November and February typically are the slowest months as would-be buyers prepare for and then recuperate from the holidays, said John Karevoll, (of) DataQuick. ‘That said, I fully expect this November to be the strongest we have had since 1988.’ Home sale prices in October also kept growing at a sizzling pace: The median price in Los Angeles County climbed 22% from a year ago to about $332,000 last month… In Orange County, median home prices hit a new record of about $440,000, a 19% increase from a year ago… Based on figures expected to be released today, the median price in Riverside County last month increased by 19% from a year ago to about $262,000.  In San Bernardino County, where wildfires disrupted some sales in late October, the median price last month jumped 24% from October 2002 to about $204,000… In Ventura County, home buyers saw a 21% price hike in October from a year earlier to $401,000.”

November 20 – PRNewswire:  “The luxury home market in California is heating up, with Los Angeles values rising to their highest levels in 12 years and San Diego homes reaching another record high, according to the Prestige Home Index(TM) by First Republic Bank… ‘The market is as hot as a pistol right now,’ said agent Myra Nourmand of Nourmand & Associates in Beverly Hills. ‘It’s just absolutely insane.’ She noted that a property which sold for $12.5 million 2-1/2 years ago is on the market today for $29 million. ‘There’s not a lot of product and there are a lot of buyers.’”

Dollar Watch:

It’s here.  Or “until proven otherwise,” I will assume that Tuesday’s significant dollar decline marked the commencement of a more problematic stage for the unfolding dollar “problem.”  The Bank of Japan's major intervention Wednesday morning may have stabilized the situation, but only temporarily. 

Dollar sentiment was surely not helped by the Treasury’s release of September “Transactions with Foreigners in Long-term Securities.” Monthly Net Purchases, having averaged almost $76 billion over the preceding six months, collapsed to a measly $4 billion.  I will not place too much emphasis on one month’s data, but this release highlights the risk of broad-based waning demand for U.S. securities.  Averaging $16 billion monthly through August, net purchases of Agency debt reversed to a negative (liquidation) $3.2 billion.  Foreigners also liquidated $6.3 billion of U.S. stocks, while purchasing net $5.6 billion of Treasuries and almost $20 billion of corporate bonds (including ABS).   Year-to-date, Treasury and Agency purchases have accounted for 63% of total purchases, this compared to 51% during 2002 and 36% for 2001.  U.S. “risk assets” are out of favor.

The financial centers of Japan, the UK (London) and the Caribbean traditionally account for a large percentage of “foreign” purchases.  What role the global leveraged speculating community plays in these transactions (as opposed to true investors) we will likely never know for sure.  But it is interesting to note that purchases from the UK were normal during September (around $12 billion), while the Caribbean turned from a buyer ($15 billion monthly avg. over the preceding 5 months) to a net seller of almost $11 billion.  The Caribbean saw agency liquidations of $8.7 billion.  It is fascinating that the Caribbean accounted for 66% of total agency transactions during September, although down somewhat from the almost 75% from May through August.  Japan had net Treasury purchases of $21.5 billion during September, with a y-t-d monthly average of $9.2 billion.  This compares to last year’s average of $2.1 billion.  Year-to-date, Japan’s purchases of U.S. long-term securities have jumped to $10.3 billion monthly compared to 2002’s $6.0 billion.  However, net monthly Agency purchases have declined about 20% to $1.9 billion.  Total Japan, UK, and Caribbean net purchases have averaged $30 billion monthly this year, compared to about $22 billion last year.  The monthly average of net Treasury purchases has more than doubled to $13.5 billion. 

Certainly, comments from our top central bankers do anything but inspire dollar confidence.

November 19 – Fed Bank of St. Louis President William Poole:  “The general public is also concerned about the large and increasing U.S. trade deficit.  Some of the concern reflects a view that U.S. exports should equal U.S. imports.  This view fails to appreciate that a country’s trade balance and its capital account are very closely related… Via basic accounting, a country’s capital account surplus is equal to its current account deficit.  For simplicity, let’s view the current account deficit as the trade deficit.  A common mistake is to treat international capital flows as though they are passively responding to what is happening in the trade account.  In fact, investors abroad buy U.S. assets not for the purpose of financing the U.S. trade deficit but because they believe these assets are sound investments, promising a good combination of safety and return.  On a personal level, every one here has the option of moving funds abroad, for example through mutual funds that invest in foreign stocks and bonds.  Why is the net capital flow into rather than out of the United States?  The reason is that for most investors the United States is the
capital market of choice.  There is no better place in the world to invest.  In sum, the United States has created for itself a comparative advantage in capital markets, and we should not be surprised that investors all over the world come to buy the product.  As investors exploit the opportunities provided by U.S. financial markets, trade deficits can arise.  Thus, my view is that our current trade deficits are not a cause for alarm because on the whole they reflect extremely positive forces driving the U.S. capital account.”

Global central bankers, especially the Europeans, must be aghast.  And (ironically), this today from a speech delivered by Dr. Poole at the Cato institute’s commemoration of the 40th anniversary of the publication of Milton Friedman and Anna Schwartz’s “A Monetary History of the United States:  “Perhaps the most important message I take away from the Monetary History is the tremendous importance of ideas in shaping monetary policy.  Bad economic analysis will almost certainly produce bad monetary policy.  The real-bills doctrine had a lot to do with the Federal Reserve’s catastrophic mistakes in the early 1930s.  Later…the theory of a Phillips curve tradeoff between inflation and unemployment played a similar role in fostering the Fed’s inflationary mistakes of the 1960s and 1970s.”

Well, I would argue that the bad economic analysis is only perpetuating some of the worst monetary policy imaginable. 

The following are excerpts from yesterday’s “Remarks by Chairman Alan Greenspan at the 21st Annual Monetary Conference, Cosponsored by the Cato Institute and The Economist.”  As a rebuttal to ECB Chief Economist Dr. Otmar Issing’s recent astute warning of the perils of unsustainable U.S. imbalances, it is pathetic.  But as clever obfuscation, it is Mr. Greenspan at his finest.  Historians will not be kind.  The Fed has clearly made the decision to dismiss the relevance of our intractable trade deficits, and it is difficult to envisage how this approach will be welcomed in the increasingly anxious foreign exchange markets. 

“My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible.  I plan this morning to head in what I hope will be a more fruitful direction by addressing the evolving international payments imbalance of the United States and its effect on Europe and the rest of the world. I intend to focus on the eventual resolution of that current account imbalance in the context of accompanying balance-sheet changes.

I conclude that spreading globalization has fostered a degree of international flexibility that has raised the probability of a benign resolution to the U.S. current account imbalance. Such a resolution has been the general experience of developed countries over the past two decades. Moreover, history suggests that greater flexibility allows economies to adjust more smoothly to changing economic circumstances and with less risk of destabilizing outcomes.

Indeed, the example of the fifty states of the United States suggests that, with full flexibility in the movement of labor and capital, adjustments to cross-border imbalances can occur even without an exchange rate adjustment

The current account deficit of the United States, essentially net exports of goods and services, has continued to widen over the past couple of years. The external deficit receded modestly during our mild recession of 2001 only to rebound to a record 5 percent of gross domestic product earlier this year. Our persistent current account deficit is a growing concern because it adds to the stock of outstanding external debt that could become increasingly more difficult to finance.  These developments raise the question of whether the record imbalance will benignly defuse, as it largely did after its previous peak of about 3-1/2 percent of GDP in 1986, or whether the resolution will be more troublesome.

My comment:  It is worth noting that the late-eighties current account deficit gave way to a small surplus with the onset of the early-nineties recession.  Clearly, today’s imbalances are of a structural nature unlike any previously experienced in the U.S.

Current account balances are determined mainly by countries’ relative incomes, by product and asset prices including exchange rates, and by comparative advantage. To pay for the internationally traded goods and services that underlie that balance, there is a wholly separate market in financial instruments the magnitudes of which are determined by the same set of asset prices that affects trade in goods and services. In the end, it is the balancing of trade and financing that sets international product and asset prices and global current account balances.

My comment:  I would argue that current account balances are more determined by relative Credit excess than “relative incomes” (the U.S. and Japan as a case in point).  This notion that ongoing capital surpluses are fueling our trade deficits is ridiculous propaganda.  Domestic lending and consumption excesses are creating new dollar balances and spreading them throughout the global financial system.  These dollar balances, then, must immediately find their way to U.S. securities and other financial assets.  It is not that we are hoarding global “savings,” as much as we are creating new dollar claims (liabilities) that must be held by our Creditors.  It is simply not a “chicken or the egg” quandary.  The new dollar balances are first created, then disseminated globally, and then “recycled” back to the U.S. securities markets and financial system.  To judge which is the driving force, the trade deficit or capital “surplus,” we need only to look first to domestic Credit expansion and consumption.

The buildup or reduction in financial claims among trading countries--that is, capital flows--are hence exact mirrors of the current account balances. And just as net trade and current accounts for the world as a whole necessarily sum to zero, so do net capital flows. Because for any country the change in net claims against all foreigners cumulates to its current account balance (abstracting from valuation adjustments), that balance must also equal the country’s domestic saving less its domestic investment.

My comment:  What?  This is nebulous, unhelpful analysis.  When an economy is in the midst of gross Credit excess, analysis is better placed focusing on borrowing and spending excess rather than the indeterminable subjects of true savings and investment.

In as much as the balance of goods and services is brought into equality with the associated capital flows through adjustments in prices, interest rates, and exchange rates, how do we tell whether trade determines capital flows or whether capital flows determine trade? Answering this question is difficult because the balancing process is simultaneous rather than sequential, so that there is no simple unidirectional causality between trade and capital flows.

… as the U.S. current account deficit rose from 1995 to early 2002, so too did the dollar’s effective exchange rate. Evidently, upward pressure on the dollar was spurred by rising expected rates of return that resulted in private capital investments from abroad that chronically exceeded the current account deficit. The pickup in U.S. productivity growth in the mid-1990s--the likely proximate cause of foreigners’ perception of increased rates of return on capital in the United States--boosted investment spending, stock prices, wealth, and assessments of future income. Those favorable developments led, in turn, to greater consumer spending and lower saving rates.

My comment:  I would strongly argue that the nineties were aberrational.  The extraordinary dynamics of this period had very little to do with a pickup in productivity, but rather the commencement of an historic financial and economic Bubble.  Much to the chagrin of the Fed, they are not today capable of re-engineering the late-nineties/early 2000’s dollar Bubble.  The cumulated supply of dollar obligations is too great and the requisite ongoing supply of new dollar claims too enormous.  Moreover, there are today competing currencies and markets unlike the monopoly the dollar held during those intoxicating Bubble years.   

The resulting widening gap between domestic investment and domestic saving from 1995 to 2000 was held partly in check by higher government saving as rising stock prices drove up taxable income. When, in 2002, that effect reversed and the federal budget slipped back into deficit, and as the U.S. economy emerged from its downturn, the gap in the current account balance widened further. After contracting in the aftermath of the U.S. stock market decline of 2000, private capital from abroad was apparently again drawn to the United States in substantial quantities by renewed perceptions of relatively high rates of return. In addition, during the past year or so the financing of our external deficit was assisted by large accumulations of dollars by foreign central banks

My comment:  I would argue that huge speculative flows were drawn to the U.S. to play the Greenspan Fed’s post-tech Bubble interest-rate collapse.  The Fed is now trapped in providing the massive speculator community perpetually low borrowing costs and a steep yield curve.  Will foreign central banks continue their unprecedented purchases in 2004?  2005?

In the end, it will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against U.S. residents that will serve as the restraint on the size of tolerable U.S. imbalances in the global arena. Unlike the financing of payments from export and income receipts, reliance on borrowed funds may not be sustainable. By the end of September 2003, net external claims on U.S. residents had risen to an estimated 25 percent of a year’s GDP, still far less than claims on many of our trading partners but rising at the equivalent of 5 percentage points of GDP annually. However, without some notion of our capacity for raising cross-border debt, the sustainability of the current account deficit is difficult to estimate. That capacity is evidently, in part, a function of globalization since the apparent increase in our debt-raising capacity appears to be related to the reduced cost and increasing reach of international financial intermediation

My comment:  I think it is fair to say that “foreign country residents” play a trivial role in financing our massive current account deficits.  “International financial intermediation” – especially the mushrooming global speculating community – has expanded right along with the Bubble in U.S. financial claims.  The derivatives Bubble has expanded right along with the “hedging” needs of the mushrooming global speculating community.  Over the past decade we have witnessed repeated examples of such Bubbles unraveling.  The dollar, as reserve currency, has only nurtured the most extreme imbalances over a protracted period.

From an accounting perspective, part of the increase in finance relative to trade in recent years reflects the continued marked rise in tradable foreign currencies held by private firms as well as a very significant buildup of international currency reserves of monetary authorities. Rising global wealth has apparently led to increased demand for diversification of portfolios by including greater shares of foreign currencies. More generally, technological advance and the spread of global financial deregulation has fostered a broadening array of specialized financial products and institutions. The associated increased layers of intermediation in our financial system make it easier to diversify and manage risk, thereby facilitating an ever-rising ratio of domestic liabilities (and assets) to GDP, and gross external liabilities to trade.   These trends seem unlikely to reverse, or even to slow materially, short of an improbable end to the expansion of financial intermediation that is being driven by cost-reducing technology

The long-term increase in intermediation, by facilitating the financing of ever-wider current account deficits and surpluses, has created an ever-larger class of investors who might be willing to hold cross-border claims. To create liabilities, of course, implies a willingness of some private investors and governments to hold the equivalent increase in claims at market-determined asset prices. Indeed, were it otherwise, the funding of liabilities would not be possible.

With the seeming willingness of foreigners to hold progressively greater amounts of cross-border claims against U.S. residents, at what point do net claims (that is, gross claims less gross liabilities) against us become unsustainable and deficits decline? Presumably, a U.S. current account deficit of 5 percent or more of GDP would not have been readily fundable a half-century ago or perhaps even a couple of decades ago.   The ability to move that much of world saving to the United States in response to relative rates of return would have been hindered by a far lower degree of international financial intermediation. Endeavoring to transfer the equivalent of 5 percent of U.S. GDP from foreign financial institutions and persons to the United States would presumably have induced changes in the prices of assets that would have proved inhibiting.

There is, for the moment, little evidence of stress in funding U.S. current account deficits. To be sure, the real exchange rate for the dollar has, on balance, declined more than 10 percent broadly and roughly 20 percent against the major foreign currencies since early 2002. Yet inflation, the typical symptom of a weak currency, appears quiescent. Indeed, inflation premiums embedded in long-term interest rates apparently have fluctuated in a relatively narrow range since early 2002. More generally, the vast savings transfer has occurred without measurable disruption to the balance of international finance. In fact, in recent months credit risk spreads have fallen and equity prices have risen throughout much of the global economy.

My comment:  I would argue a rapidly declining dollar -- in the face of ballooning foreign central bank balance sheets and the resurgent economy and stock market -- while not on the surface evidence of stress, certainly portends serious difficulties financing future deficits.  Falling global risk premiums and surging international equity markets are evidence of the evolving global nature of dollar claims/liquidity inflation.

To date, the widening to record levels of the U.S. ratio of current account deficit to GDP has been seemingly uneventful. But I have little doubt that, should it continue, at some point in the future adjustments will be set in motion that will eventually slow and presumably reverse the rate of accumulation of net claims on U.S. residents. How much further can international financial intermediation stretch the capacity of world finance to move national savings across borders?

…More important than the way that the adjustment of the U.S. current account deficit will be initiated is the effect of the adjustment on both our economy and the economies of our trading partners. The history of such adjustments has been mixed. According to the aforementioned Federal Reserve study of current account corrections in developed countries, although the large majority of episodes were characterized by some significant slowing of economic growth, most economies managed the adjustment without crisis. The institutional strengths of many of these developed economies--rule of law, transparency, and investor and property protection--likely helped to minimize disruptions associated with current account adjustments. The United Kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, Mexico, Thailand, Korea, Russia, Brazil, and Argentina, to name just a few.

Can market forces incrementally defuse a worrisome buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance…

We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.   The experience of the United States over the past three years is illustrative. The apparent ability of our economy to withstand a number of severe shocks since mid-2000, with only a small decline in real GDP, attests to the marked increase in our economy’s flexibility over the past quarter century…

Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption. And if other currencies, such as the euro, emerge to share the dollar’s role as a global reserve currency, that process, too, is likely to be benign. I say this with one major caveat. Some clouds of emerging protectionism have become increasingly visible on today’s horizon.

It is interesting to note that Dr. Issing warned that “persistent current account deficits – and, in particular, trade deficits – may give rise to protectionist pressures in the deficit country.” Conversely, Mr. Greenspan is saying that emerging protectionism could encumber further globilization and in the process impede the the “benign resolution” of U.S. imbalances.  Clever Mr. Greenspan, clever... I would strongly argue that today’s most evident risks to “benign resolution” - including rising protectionism, GSE and financial accounting, mutual fund improprieties, and the general question of the integrity of the U.S. financial sector/financial fragility – are all the predictable consequences of a protracted period of ultra-easy money and overly-accommodative monetary policy.  We have in store an arduous adjustment period, and our Federal Reserve appears well-organized to pin the blame elsewhere.  We'll know better.   

Mr. Greenspan can write pages about the trade and current account deficits yet somehow avoid the issue of Credit excess.  Mr. Chairman, your agency publishes vast amounts of data that provide a compelling explanation for our now structural trade deficits.  Instead, we are left with your frustratingly disingenuous “analysis.” 

Mr. Greenspan now habitually chooses to muddy the waters with references to “globalization,” “flexible economies,” “productivity,” “technological advancement,” “financial intermediation,” and the old “savings less investment” muck.  The truth of the matter is anything but cryptic:  As an economy, we borrow and spend way too much, while producing too little. We speculate way too much and invest way too little.  We lack economic self-sufficiency.  And despite years of cumulating imbalances, our central bank irresponsibly refuses to address these issues.  Rather, the Fed is leaving it to the markets to begin the disciplining process.  The markets are listening anxiously, but Alan Greenspan’s not talking straight.  It’s going to catch up with him.  After all, market participants are known to be rather gullible when prices are going up, only to become much more skeptical analysts when prices are in retreat.  The same old nonsense from our Fed just won’t cut it any longer.

For some time, Chairman Greenspan has been the leading cheerleader for the much touted “resilient” and flexible New Age U.S. economy.  I have argued that a stubbornly over-zealous Credit system was in reality responsible for the seemingly irrepressible U.S. economy.  I believe this dynamic will now haunt the dollar. Unfettered liquidity and Credit creation have worked miracles, but Bubbles have grown so large there’s no way out short of a great deal of pain.  Pain is no option.  Amazingly, instead of moving to rein in unprecedented imbalances, the Greenspan Fed has clearly opted to sustain them.  He’s told the markets as much. It’s now up to the markets.