Ramblings on international inside money and reserve systems (3/25/2014)

This post is another attempt to figure out some things that have always bothered me, but perhaps it might be of use to other people as well. I will caution that is by someone who is not a monetary economist by training, I am hopelessly out of my depth here, and I fully expect to be told so. Nevertheless, writing it was a useful exercise for me, and I hope reading it will prove the same for others.

It will borrow (i.e., cut and paste) from an earlier column on the global savings glut entitled “Can anyone be 1930s France anymore?” but what got me thinking about these issues again was a) the BoE explanation of endogenous money and b) the persistent belief that it is essential for the US to run trade or current account deficits in order to provide the world with sufficient USD liquidity. In other words, there seems to be a view that the status of the USD as the world's reserve currency depends on the US running current account deficits.

Let me start with b) because I've dealt with it inside the 140 twitter format but it might be useful to spell it out a bit more clearly. The fact is that both the UK before 1915 and the US before 1962 ran current account surpluses but still were the world's monetary hegemons. This is because both the US and the UK ran very large capital account deficits that met the world's needs for international liquidity. Formally, if the country at the center of the monetary system has a substantial excess of domestic private savings over domestic private investment, then those savings can be exported to the rest of the world. Furthermore, the export of domestic private savings could be so large that it is insufficient to fund domestic government dissaving, leaving that to be funded by the Rest of the World, in turn providing RoW with reserve assets. This model of pre-1915 UK and pre-1961 US behavior also seems to picture German behavior inside the ECU. More generally, I also like this model because it treats the capital account with the respect that I think it deserves (yes, I know the algebra). This idea of relatively autonomous capital account behavior is what is behind my view that the Eurozone crisis (certainly its boom phase) would have been no different even with national currencies (which is the post immediately preceding this one). It also fits with my intuition that greater financial market turbulence is occasioned around the world by marginal shifts in the net US demand for external assets than by shifts in the net US demand for external goods (which latter, I understand, at second hand at least, is the GaveKal view). And of course, that is what the taper tantrum is all about.

What does this have to do with a) above or the Bank of England paper on money creation in the modern economy? I see the key point (at least for my purposes) as this from p.1 of the BoE note.

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf

“Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)”

Transposing this to the international arena, I would make the case that it is wrong to infer from the increase in global reserves that occurred between 2002 and 2007 that there was also a simultaneous increase in global savings (i.e., a global savings glut).

And now to cut and paste from my earlier note as to why it makes no sense to speak of a global savings glut from 2002-2008. “Intuitively, one might have thought that such an insufficiency of investment versus savings might have been more likely to occur between 1997 and 2002 as a result of the Asian crisis and the global technology bust, or alternately, during the sharp fall in global trade that followed the collapse of Lehman. When considered in this light, the GSG hypothesis seems based in part on a category error. In essence, the peak period of the GSG is identified by the peak rate of global reserve accumulation. The category error is that the hypothesis treats reserve accumulation under fiat currency reserve asset regimes as being indistinguishable from reserve accumulation under the classical gold standard. However, as Jacques Rueff pointed out half a century ago, fiat currency reserve regimes differ from (the theoretical operation of) the classical gold standard in that there is no necessity for the deficit country at the center of the system to undergo adjustment through monetary contraction and reduced investment as long as its liabilities are treated as substitutes for gold. This explains the otherwise anomalous fact that the peak of the GSG also coincided with extremely high rates of US public and private dissaving and a sharp increase in US liabilities.

By its nature, the fact that algebraically the increase in Chinese saving coincided with a rise in US dissaving makes it hard to speak of a global savings glut though there was obviously an increase in reciprocal regional imbalances with increases in chinese claims offset by increases in US liabilities. Similarly I find it difficult to understand why the period is designated a GSG period when it might as well be designated a period of a global (mal)investment boom, which follows from the algebra.

Meanwhile, I do find Bernanke’s (and others’) periodic analogies of Chinese behavior during GSG to French behavior in the late 1920s/early 30s to be inexact. The refusal of a surplus country to permit monetary expansion in response to increased gold inflows can lead to a shortfall in global aggregate demand since the surplus country will not grow faster while the deficit country would likely be forced into contraction. But in a fiat reserve regime, reserve accumulation continues to permit fiscal or quasi-fiscal (via GSEs in the US case) expansion in the deficit country at the center of the system. This explains why the GSG period also coincided with a higher level of global growth and higher levels of global investment than the periods immediately before or after. My point is that an excess of savings of “outside money” if unsterilized in a gold standard system can lead to a global excess of savings over investment. I see no evidence that this occurred GLOBALLY during the period 2002-2007.”

In a quick TWT conversation with Frances Coppola yesterday, she referred to the US trade deficit as international endogenous money. I think that makes a lot of sense, and per the post above, I was trying to get at a similar idea. Another point I've made (also in 140) is that treat the increase in global reserves as evidence of increase in global savings is similar to treating an increase in M2 or M3 as evidence of an increase in a country's domestic savings, which I think we we would all consider a mistake.

But then, this takes us back to the question of whether or not US trade and current account deficits are essential to grease the wheels of global liquidity. As I laid out above, it might be possible for exports via the capital account to do the same (as the UK did before 1915 and the US did before 1961). In theory, yes, but I think one crucial difference arises from the nature of the claims that such a system would create. A capital exporting reserve hegemon would not be subject to the Triffin Dilemma (which, in a nutshell, states that too small a current account deficit is insufficient for global liquidity, while too large a current account deficit raises questions about the quality of the reserve asset). However, under such a system, the banking system of the reserve hegemon might not expand credit as quickly because it would by construction hold assets in large non-hegemonic capital importers that were perceived to be of lower quality, which might tend otherwise to constrain the expansion of their balance sheets. Conversely, a reserve hegemon that is simultaneously a large current account deficit country can for a considerable period of time (until there is a regime shift and the hegemon is dethroned) provide RoW banking systems with the highest putative quality of collateral (USTs in this instance), permitting much more rapid expansion of global credit. I think that is exactly what happened in the period in question. This in turn would account for something that has always bothered me—the fact that the US functioned as the world's buyer of last resort in goods markets from 2002-2007 but that in 2008, the Fed became the world's lender of last resort.

Anyway, there is obviously a lot more to chew on here but I did want to get this out there. Comments especially welcome. Questions, not so sure I can really answer them.