[phil_20686]

According to my guesstimates, the US sovereign debt is about half held by foreign investors. Since debt is an "asset" which they have bought for cash, this gets entered into your nations current account as an export.

While, like stock markets, FX markets are volatile in the short term, in the long term their mean reversion trend is very strongly towards balancing the current accounts. If you are an exporter your currency gets stronger, if you are an importer then your currency weakens. In this way, eventually, we move to wards an equilibrium where every currency area produces roughly the value of what they consume.

As is well known, the US, and many western countries, labour market recovery has been sluggish. Open possible explanation is that western labour is overvalued on a world stage, and if our currency was allowed to fall, reducing the value of our labour, that would be good for exporters and help to re balance our economy into an export led recovery. Thus, I conclude, that a large deficit, if bought largely by foreigners, will overvalue your currencies labour. In normal times this overvaluation is small, but, for example, in the US at the moment, your deficit is predicted to be around 12% of GDP, if half is bought by foreigners that will overvalue your currency by 6%. That is a Big Deal in a world of marginal economics. If the dollar currency dropped 6%, you could expect significant re-shoring over the next few years.

Of course, in the long run, this is part of a well overdue shift of consumption from west to east, and a corresponding shift of production from east to west. Such large imbalance's are only tenable in the short term. However, I am more interested in the short term and medium term effects. Could this FX effect make austerity the right play? If austerity leads to a massive weakening in the currency, that is generally good for employment. (which is why people are annoyed with china doing the opposite). Although it is bad for consumers, and bad for retailers.

My analysis could be summarised as this
(1) By selling large quantities of both private and public debt to foreign savers, the west has kept its currency artifically strong.
(2) Doing so has allowed us to create a massive world imbalance between consumption and creation that would normally be impossible, due to the exchange rate mechanism.
(3) In order to correct this we need to have less debt. This may have the heretofore unpredicted effect of weakening our currencies vs eastern currencies, and improving employment.
(4) The side effect would be a lower standard of living in terms of cheap produce from the east, although many high value items made in the west would be unaffected.

I have never seen this argument made by austerity advocates, it seems to me to be both cogent and somewhat compelling. I'd like to hear your opinions.

[hrothgar]

Hi Phil

I want to make sure that if I understand the argument that you are making...

From the sounds of it you are saying

1. The Chinese are manipulating exchange rates to keep their currency artificially weak and the dollar artificially strong.
2. They are doing so by purchasing US debt
3. If the US stops issuing debt, then the Chinese can not purchase debt
4. Therefore, the Chinese can't manipulate the exchange rate and the US dollar will fall in value

If this is, indeed, the core argument, I'm not sure that I buy it.

There are plenty of ways for the Chinese to play around with their exchange rate without purchasing newly issued debt.

For example, the Chinese could purchase real estate, much as the Japanese did back in the 80s.
The Chinese could purchase already existing bonds, state bonds or munis, or virtually anything...
...



2. If the US government real

[phil_20686]

hrothgar, on 2011-November-29, 12:50, said:

If this is, indeed, the core argument, I'm not sure that I buy it.

There are plenty of ways for the Chinese to play around with their exchange rate without purchasing newly issued debt.

I didnt mean to particularly center on the Chinese.

Yes, I agree they could buy other stuff. However, for most things that they could think of buying, it would be a self defeating strategy, as the price would go up. For example, market capitalization of the NSE and the NASDAQ together is only about 18 trillion dollars. 6% of gdp amounts to something like 1trn a year, so it would rapidly drive up these stocks, and further, when they stop buying and the price drops, they could not really unload them easily. A bond on the other hand can simply be held to maturity. Thus the Chinese treasury would take much bigger losses if it engages with this strategy on something that was not bonds. Bonds are really Ideal for this as the holding will expire automatically, without having to be sold.

So the global secondary US bond market is about 30trn. That would be big enough to sustain it for a while. Of course, this would start to shrink if sovereign gilts were lessened. Not sure what proportion of this is treasuries vs corporate debt.

[hrothgar]

phil_20686, on 2011-November-29, 13:01, said:

I didnt mean to particularly center on the Chinese.

Yes, I agree they could buy other stuff. However, for most things that they could think of buying, it would be a self defeating strategy, as the price would go up. For example, market capitalization of the NSE and the NASDAQ together is only about 18 trillion dollars. 6% of gdp amounts to something like 1trn a year, so it would rapidly drive up these stocks, and further, when they stop buying and the price drops, they could not really unload them easily. A bond on the other hand can simply be held to maturity. Thus the Chinese treasury would take much bigger losses if it engages with this strategy on something that was not bonds. Bonds are really Ideal for this as the holding will expire automatically, without having to be sold.

There is a large secondary market for bonds. In turn this means

1. The same type of price effects impact the yield on treasuries currently held by the Chinese
2. The Chinese could always buy up existing bonds rather than new bonds

[phil_20686]

hrothgar, on 2011-November-29, 12:50, said:

If this is, indeed, the core argument, I'm not sure that I buy it.

There are plenty of ways for the Chinese to play around with their exchange rate without purchasing newly issued debt.

For example, the Chinese could purchase real estate, much as the Japanese did back in the 80s.
The Chinese could purchase already existing bonds, state bonds or munis, or virtually anything...
...

One farther point. Everything I know says that large current account imbalances are impossible in the long term, as the exchange rate should move to choke it off. However, we have maintained one for nearly three decades. The only possible explanation is that assets have been moving from west to east to balance the accounts. This clearly hasnt happened in Real Estate or the Stock market, which are still mostly domestically owned. The only remaining candidates are bonds. In fact this makes sense. The imbalance has coincided with huge savings in the east and huge debts in the west. Since savers often buy debts as a relatively low risk way to get some returns, it all makes sense. Thus I regard the imbalance of consumption as prima facia evidence that bonds are being bought in sufficient numbers to influence the exchange rates. I think that makes sense.

[phil_20686]

hrothgar, on 2011-November-29, 13:09, said:

There is a large secondary market for bonds. In turn this means

1. The same type of price effects impact the yield on treasuries currently held by the Chinese

I dont think this is true. If you hold a bond to maturity you get interest at the rate it says irrespective of what is happening in the market. Once a bond is issued, changes in yields come from changes in the price of the bond, not from changes on the interest rate, which is fixed. At least that is how I understand them to function.

[hrothgar]

phil_20686, on 2011-November-29, 13:12, said:

One farther point. Everything I know says that large current account imbalances are impossible in the long term, as the exchange rate should move to choke it off. However, we have maintained one for nearly three decades. The only possible explanation is that assets have been moving from west to east to balance the accounts. This clearly hasnt happened in Real Estate or the Stock market, which are still mostly domestically owned. The only remaining candidates are bonds. In fact this makes sense. The imbalance has coincided with huge savings in the east and huge debts in the west. Since savers often buy debts as a relatively low risk way to get some returns, it all makes sense. Thus I regard the imbalance of consumption as prima facia evidence that bonds are being bought in sufficient numbers to influence the exchange rates. I think that makes sense.

Define "we" and "large"

On the "we" front...

The US dollar serves as the world's reserve currency which means the the US has considerably more leeway to run large deficits. For a while, I thought that the Euro had the potential of supplanting the dollar as a reserve currency. Guess I was wrong about that one...

On the "large" front... It is possible to run constant deficits so long as expected growth is large enough to sterilize in the long run.

FWIW, back when I did economics seriously I tended to stay far away from macro as to avoid this sort of poppycock.
Microeconomics and game theory are much more relaxing

[phil_20686]

by we I meant "the west" or the "G7" or whatever you want to call developed economies.

Being a reserve currency gives you more leeway only in the sense that you can print a lot more money before you get to penaly levels of inflation. I.e. you can take from the savers of countries other than your own. That is a massive advantage, but I'm not sure its relevant here.

Running deficits perpetually is definitely possible, although most of the thought experiments that I know do not consider the possibility of FX rates having a meaningful effect on employment. Of course, if you run a few % deficit and only a small amount is bought by foreign investors (there is always some demand among domestic sources like pension funds), then its hard to imagine this is a large. Moreover, its likely you are buying some of others countries debt for a net change of zero. As far as I know it has never been the case that foreign ownership of bonds has conceivably been large enough to possibly have an influence on exchange rates, given the way productivity increases and decrease move you away from equilibrium generally.

[whereagles]

Last time Germany went on an austerity "cure" a guy with half-a-moustache came up.

It's the way of teh devil.

[iviehoff]

Let's look at your basic premise, that more debt exported strengthens your exchange rate.

Let's think about this more carefully, because it seems counterintuitive. The more debt you have, the weaker your balance sheet, surely the weaker the value of your net assets, and the less likely foreigners would want to buy in, so the currency goes down. That's what normally happens when a country becomes more indebted. I think we know that is what happened in places like Greece and Italy before they were in the Euro.

But it turns out that by defining the scenario in certain ways, you can obtain the appearance of the phenomenon you desire.

Suppose you have a fixed quantity of debt, all held by locals. Then some foreigners come along and buy some of that debt off them. That will result in your exchange rate going up, because there is increased demand for your currency, or assets denominated in your currency, which amounts to teh same thing. Note that you didn't decide to export debt, rather the foreigners decided they wanted to buy your debt, and that is what made your currency go up - the fact that your assets had become more desirable, not the fact of you deciding you wanted to export debt.

Suppose you want to increase the quantity of debt you have. Now actually you don't really have a choice between selling locally and exporting, because the finance market is pretty globally integrated, and those who turn up to buy assets will be who they are. If you want to sell more debt, what you have to do is is increase your interest rate. Increasing your interest strengthens your currency, because it increases the demand for your assets. Then putting out debt onto the market tends to weaken it. Also maintaining a persistently high interest rate tends to result in the currency weakening over time, as you are paying out loads of cash to foreigners weakening your balance sheet.

So I think your proposition is basically wrong. Issuing more debt does not strengthen your currency, in general it will do the opposite. Rather in order to issue more debt, you may have to increase the interest rate, and it is that which will temporarily strengthen your currency.

Notice how governments have kept interest rates very low at the moment. This is wonderful if you are paying on a treasury-linked variable exchange rate. But in the real market you can't actually get money at these cheap prices. Capital is scarce at the moment, reducing its price is paradoxical. Such low interest rates in a time of financial depression are actually a mechanism for a hidden tax on those who have financial capital - savers get sub-market returns on their savings, and the beneficiaries of that are opaque but include banks, thus reducing government's need to prop them up.

Now for your headline question. It all depends what you think austerity "working" means. The aim of austerity is to reduce indebtedness. If you reduce indebtedness, then your balance sheet strengthens, your assets are more attractive, and your currency should go up in the long run. However, as we have realised, this is somewhat confounded by what interest rates you can set. A cartel of governments setting low interest rates, ie an artifically low price for the money they need, queers the market somewhat. You can't have a situation where everyone's exchange rate falls. Our exchange rates could, in principle, all fall against the Chinese exchange rate, but they fix it.

[phil_20686]

iviehoff, on 2011-November-29, 14:57, said:

Let's look at your basic premise, that more debt exported strengthens your exchange rate.

Let's think about this more carefully, because it seems counterintuitive. The more debt you have, the weaker your balance sheet, surely the weaker the value of your net assets, and the less likely foreigners would want to buy in, so the currency goes down. That's what normally happens when a country becomes more indebted. I think we know that is what happened in places like Greece and Italy before they were in the Euro.

It seems like this is basically you agreeing with my premise here. The currency falls when they stop buying your debt. Currency exchange rates are basically set by the demand for them. Since, to buy my debt, which I see in $, you have to buy $, it is definitely true that buying debt should drive up the exchange rate. Of course, when you either stop issuing debt, or foreigners stop buying it, your currency declines to its `natural` value. I agree that the seller does not normally get to choose whom to sell to, but that isnt really the point, it only matters whether the people who buy your debt have to buy extra currency in order to do so.

Another way to look at it is to note that buying a debt is is not appreciably different from buying the asset that is backed by the debt. E.g., you could buy a mortgage, or you could buy the house yourself and rent it to the occupant.


"Working" to me means reducing indebtedness while also having a recovery in the private sector. Reducing the deficit while unemployment climbs into double figures is not acceptable. Obviously there has to be some pain, but there are problems on both sides.

[WellSpyder]

phil_20686, on 2011-November-29, 15:18, said:

It seems like this is basically you agreeing with my premise here...... when you either stop issuing debt, or foreigners stop buying it, your currency declines to its `natural` value.

Phil, I think you are underestimating the importance of the distinction iviehoff (and indeed hrothgar) is making. Foreigners buying debt denominated in your currency has nothing to do with whether or not you are issuing debt. The overseas demand for $-denominated debt might actually rise if the US gov't stopped issuing new debt.