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Wednesday February 17, 2010 - 16:43:03 GMT
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Forex Blog - China Dumps Treasuries? US Fiscal Crisis Imminent? Not so Fast.

I sent a copy of Martin Wolf’s article on Niall Ferguson’s Chicken Little call on the US fiscal imbalance for a reason.  I think some in the financial press and markets are only armed with a hammer and everything in sight looks like a nail (no pun intended – Nail Ferguson) when it comes to large fiscal deficits for developed economies.  People need to distinguish between near-term deficits (surging) and long-term sustainability.  Near-term G in the GDP = C (consumption) + I (investment) + G (government spending) + X (net exports) is massively important to filling the void left by declines in private sector activity (C + I + X).  Not doing so would add more to the deficit and debt levels than failing to fill the void with deficit spending, however distasteful and inefficient.  Moving now to tighten fiscal policy will surely see GDP crash.  As Wolf notes the likelihood of X filling the void left by crashing C and I is low…would require a massive decline in the real effective exchange rate which could have unintended consequences of driving market rates up and the economy into a deep depression.   And as Wolf also pointed out in his FT column, in a major contraction such as the one we have just experienced and are slowly coming out of means that the cost of surging deficits in the near-term is less than the cost added to servicing this debt over the long run. 


And government policy is not stagnant in theory, though the reality of gridlock is arguably more troubling than large deficit spending/tax cuts – the reason why US debt is AAA is because of government capacity for collecting tax and the economy to grow.  The NYT today explores why Washington gridlock is perhaps the greatest risk to US AAA rating as opposed to near-term massive budget deficits.   (


The other argument many float for why the economy has recovered from a massive decline is the Fed’s QE and emergency liquidity measures (and TARP?  Most conservatives deny this played any constructive role in stabilizing banks and assisting the recovery) are what have restored growth.  This argument is entirely misleading.  Yes the Fed’s actions helped keep the banking system open and the payments system open which no economy could live for long without.  And yes the Fed’s liquidity measures and ZIRP have goosed up stock prices, risk assets and commodities.  But no recovery was ever made on a foundation of asset price reflation.  If the Fed were the engine for the real economy growth since the summer we would have to see it in the velocity of money and the demand for money.  These remain depressed.  Moreover, even the Fed insinuates (and as Wolf notes research from major multilateral institutions supports) that there is not much additional benefit to the economy, market liquidity and credit creation from the Fed doing ever more of what they have already done…in other words QE has reached its limits.  Surely Bernanke is not in favor of a massive Greece-style contraction in G right now. 


Greece is in a straight jacket in terms of policy choices – function of monetary union…fiscal policy constraints in the Maastricht Treaty are there because of the absence of political union and monetary policy including currency policy is not there to cushion Greece which is around 2.7% of GDP for the Euro Zone.  Greece is going to be in a major economic funk even when the rest of the Euro Zone is recovering in a more robust fashion as its primary policy orientation ahead is public deleveraging…a major rewrite of cradle-to-grave social contracts.  The US government has none of these constraints apart from market confidence.  So the “Nail The Hammer Ferguson”-view rests on a loss of market confidence in the ability of the US government (and for some to the right of Nail The Hammer this includes Fed credibility).   Forget for a minute that in prior periods of large US deficits as a share of GDP, America has found a way to reduce deficits…there is no history of default, runs on the dollar or IMF bailouts.  Yes the US has huge political challenges in the long-term to run budget surpluses and reduce debt…raise taxes (VAT seems increasingly under discussion), raise retirement age for Social Security, means test Medicare and slash government spending.  I think most people on the planet believe the US will get there in time otherwise the yields on US government debt would not be as low as they are (not far from post-war lows). 


So I can’t help but look at the latest TICs data from US Treasury and laugh at the airwave bloviating that China reduced its US Treasury holdings by $34bln in December as the sign of the beginning of the end of the US as a AAA rated country and the dollar as the world’s reserve currency.  Folks China still has $755bln in Treasuries after the December downsizing (3%) and as long as it pegs the CNY to the USD by definition it will be a net buyer of US Treasuries.  The notion of diversification for China is real.  But can anyone imagine what would happen to the price of say gold if China tried to move a sizeable portion of its reserves into gold…or $34bln even?  And as far as diversifying into the EUR as an alternative reserve currency has turned up a little stinky as the great recession predictably exposes the soft underbelly of the single currency and EMU. 


And then there is market chatter from Treasury traders who say that China was mainly selling T-bills in December (most liquid and near-cash) and likely sat on the cash until February when it returned to the US Treasury market in a noticeable way buying the belly of the curve.  China is all in USD and UST.  The only time to question this view is if and when it floats its currency.


I think the period ahead requires we use an assortment of tools and careful analysis and not fall into the mostly politically charged debates about the efficacy of fiscal and monetary policy and see every deficit as a crisis waiting to happen.  Don’t fall for the Nail The Hammer Ferguson world view.


David Gilmore    




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