Brad Setser: Just Because the Dollar Has Fallen (Against the Euro) and the Current-Account Deficit Is Shrinking (as a Share of GDP) Does Not Mean that the Future Is Rosy

Brad Setser writes:

The balance of financial terror, circa August 9, 2007: Back in early 2004, former Treasury Secretary Lawrence Summers highlighted... [the fact that] China – and others – relied on the US for demand that their economies were not generating internally, and the US depended on China – and others – for financing... "a situation where we [in the US] rely on the cost to others of not financing our current account deficit as assurance that financing will continue."... China has a highly concentrated -- and rapidly expanding -- position in US dollar-denominated bonds.  It depends, wisely or unwisely, on the US to provide a somewhat stable store of value for China's external savings.  The United States, in turn, is extraordinarily dependent on China’s government for external financing.... China now holds about a trillion dollars worth of US bonds.   That is about 1/3 of China’s [annual] GDP.... Summers noted... in early 2004:

There is surely something odd about the world’s greatest power being the world’s greatest debtor. In order to finance prevailing levels of consumption and investment, must the United States be as dependent as it is on the discretionary acts of what are inevitably political entities in other countries? It is true and can be argued forcefully that the incentive for Japan or China to dump treasury bills at a rapid rate is not very strong, given the consequences that it would have for their own economies. That is a powerful argument, and it is a reason a prudent person would avoid immediate concern. But it surely cannot be prudent for us as a country to rely on a kind of balance of financial terror to hold back reserve sales that would threaten our stability....

In 2004, China and Japan combined to add around $400b to their reserves in 2004.  In 2007, China alone is on track to add $500b to its reserves (counting the CIC) this year.... If China’s government wasn’t willing to issue RMB bonds – whether PBoC sterilization bills for CIC long-term bonds – to buy dollar assets, the global economy wouldn’t balance. At least not the way it does now....

Yet the United States' large and growing dependence on the willingness of China’s government to continue to act as an intermediary rarely attracts a lot of popular attention. It is just part of the economic landscape, sort of like the United States need to import roughly 14 mbd of oil every day. But I suspect that there is an underlying unease, a concern that the balance of financial terror may not prove to be as stable as the balance of nuclear terror proved to be during the cold war. Every now and then the United States' need for Chinese financing does attract a lot of attention. Yesterday was one such day.

With the collapse of the housing boom, the domestic rebalancing inside the U.S. has commenced. I won't say so far so good, but I will say so far not a complete and total disaster. It looks as though the U.S. could manage a steep decline in the capital inflow from Asia accompanied by a decline in imports--people would feel poor and be unhappy, but it would not have to lead to mass unemployment here.

But Asia's rebalancing has not commenced. The dollar is our currency, but--to paraphrase something John Connally once said--it is now or is about to be their problem.

Comments

[Scott Martens]

I am put in mind of the tagline to Percy Adlon's cult classic "Rosalie Goes Shopping":

When you're $1,000 in debt, it's your problem. When you're $1,000,000 in debt, it's the bank's problem.

[Winston]

Not everyone would feel poor and unhappy with a decline in U.S. asset prices and a lower dollar. As long as the job market remains reasonably good, I stand to benefit hugely as a young landless professional who produces an internationally traded product. I might, however, feel differently if I had just bought a $800,000, one bedroom house with no money down or if I were in a service industry.

[Barry]

"...as a young landless professional who produces an internationally traded product."

Only to the extent that that product can't be produced in other countries.

[Winston]

But you have to realize that a falling dollar makes the products produced by Americans cheaper to everyone else and thus easier to produce here and harder to produce somewhere else.