(Part 1, 2) In my previous posts, I focused as much as possible on the paper's linkage of Bush Administration policies and the optimistic narrative behind BW2. Roubini & Setser seem to believe, and I can't imagine why anyone would not, that belief in the viability of this hypothetical "Bretton Woods 2" is strongly correlated to a belief that the overall trend in government policy in the developed world is positive. Incidentally, it's a bit of an oversimplication to say that this is narrowly connected to George W Bush; the slavish devotion of the US political establishment to the financial services industry is a historic constant, and the US government is only the best-documented handmaid; European and East Asian governments have a slightly less servile relationship, but a servile one all the same. Moreover, the trends exemplified by the Bush Administration are actually global.

However, Roubini & Setser would probably object that there is a good deal more to their analysis than that, and indeed there is. First, if the point of the paper were merely, "The BW2 is not sustainable because there's little reason to believe the rest of the world can absorb $700 billion of hot money every bloody year," then there would be little point in writing 55 pages on the subject. The authorities usually do have an explanation why the system will work, and in finance, where faith is everything, it's difficult to defend one prediction of where the dam will burst against another prediction. There is, in fact, a good deal more.

Having got the political material off my chest, I'll presently move on to the substance of the paper.

The question of when and how the dam will burst, or what that bursting dam will look like, and how market participants will brace themselves against a bursting dam, are the real points to consider.

WHAT ABOUT JAPAN?

Many expect the [Ministry of Finance-which controls Japan's central bank-JRM] to intervene to defend the 100 yen to the dollar rate. Private Japanese investors are willing to take on the dollar risk required to get the additional spread on dollar assets in part because of expectations that the MOF will step in the market to prevent a large rise in the yen’s value. The Japanese MOF no doubt hopes that the threat of its intervention will be enough to defend the yen. The Japanese government probably thinks that it already has enough dollars, and would rather have other actors take on the risks associated with holding dollar assets. The capital losses on the dollars the Japanese purchased at the end of 2003 and in early 2004 from the yen’s fall at the end of 2004 are not trivial.

At the end of the day, it seems unlikely that Japan will stop financing the US altogether. If private Japanese investors are unwilling to finance the US, the MOF and the BOJ will step in and resume their intervention. It is reasonable to assume that Japan’s dollar accumulation - both public and private - will continue to match its current account surplus. However, this alone won’t be enough to sustain the Bretton Woods two system if other central banks cut back on their dollar reserve accumulation.

WHAT ABOUT THE EU?

When we speak of the EU, we'll need to distinguish between the Euro-Zone + Scandinavia (the 11 countries using the euro as their currency, plus Denmark, Norway, and Switzerland) and the rest of the zone. The UK is the other major external deficit-running country in the world; in contrast, the EZ+S is running colossal surpluses (CAB surplus of $173 billion in 2004; see R & S, p. 17). This is offset by the UK's $43 billion deficit, and Central Europe's $44 billion deficit. For the UK and Central Europe, these are relatively recent and probably won't last as long as our deficits have, but they clearly impinge on the ability of the EU to absorb US deficits.

However, it is unlikely that Europe will opt to join Asia in providing large amounts of reserve financing to the US. The ECB is no doubt willing to intervene on a small scale to try to send a signal to the market should the Euro overshoot on the upside - but that is a far cry from the massive intervention and large scale reserve accumulation that would be needed to shift some of the burden of financing the United States’ large current account deficit from the governments of Asia to the governments of Europe. The hurdles to using the ECB’s balance sheet to provide large amounts of financing to the United States are enormous.

HOW DIFFERENT IS BW2 FROM BW1?

R&S point out some important differences between the two systems:

Bretton Woods two lacks institutions to discourage free riding and facilitate agreement on how to share the burden of financing the US. The original Bretton Woods system rested on a formal commitment by all parties to maintain fixed (but adjustable) parities to the dollar. While many countries do now peg to the dollar, and others informally intervene to prevent their currencies from appreciating against the dollar, no comparable commitment underpins the current international monetary system.

Moreover, as Barry Eichengreen (2004) and others have emphasized, the US was only able to sustain the dollar-gold parity in the 1960s because the world’s major central banks - at the time the key players were mostly European central banks - agreed not to trade their dollar reserves for gold. After 1965, the official dollar reserves exceeded US holdings of gold at the established gold-dollar parity (US gold holdings fell from $20 billion to $10 billion during the course of the 1960s). There was an obvious collective action problem. Any individual central bank would be better off if it converted its dollars to gold before the US devalued relative to gold, or closed the “gold window.” But if all central banks sought to convert their dollars into gold, the dollar-gold parity would break down.

Also, there is no institutional coordination of central banks; while there is still a BIS, an IMF, and an OECD, just as before, these institutions are far more passive and reactive than the BW1 obligations were.

WHEN WILL THE DAM BURST?

I've asked this question before; R&S offer the most alarming response I've seen:

Our dominant view is that growing signs of strain will emerge in the course of 2005. Signs of strain is not quite the same as a collapse: key actors may hobble through 2005 torn between their desire to protect themselves from the risk that Bretton Woods 2 will come to an unpleasant end and their innate conservatism. Many intermediate steps have not been tried. China is likely to try to make small adjustments in the peg before it accepts a larger revaluation, let alone a managed float. Should the euro’s rise resume, small-scale ECB intervention may succeed at signaling to the market - at least for a while - that the euro has risen (the dollar has fallen) as far as can be expected. Market participants may be reluctant to challenge the Japanese MOF and risk being overwhelmed by the resumption of large- scale Japanese intervention.
[p.27]

We also suspect that these half steps will not work for long. A small revaluation of the renminbi won’t end expectations that the renminbi will appreciate more. Capital inflows will continue, fueling faster reserve accumulation that the PBOC would like. In the end, we doubt the world’s central banks will not prove willing to add another $1 trillion to holdings of dollar reserves to provide the financing the US needs to allow the US current account deficit to continue to expand, and, without continued inflows from the world’s central banks, we doubt sufficient private financing will be available for the US to sustain its current trajectory through the end of 2006.
[p.28]

The elephant in the world economic room is the now $660 billion US current account deficit. At least $465 billion of that comes from foreign central banks. It is an odd Nash equilibrium. They take our paper, which they know will one day be worth less than it is today, in order to be able to sell us products, which keeps factories growing. How long can the game continue? In the case of China, it may continue until the have established their own internal equilibrium of jobs for the hundreds of millions of peasants moving from the farms looking for a better life.

It is not a matter of things staying the same. There is in fact no Nash equilibrium into which the world has settled. We are still "playing the game" and some players may be opting to take advantage of others. The system itself is inherently unstable,...

Brad Setser, naturally, has some remarks to make about his own paper on his web log (he wonders if BW2 vanished without anyone noticing-a mortifying concept if he had only just published a rough draft of a paper explaining that it was doomed to implode in about two years!).

Let's assume that China's new reserve accumulation in January was $20 billion [...] Suppose the other ten countries [...] pace of reserve accumulation then [was] around $10b.

Then reserve accumulation by eleven of the biggest emerging economies [...] totaled about $30 billion in January (with $16b in offsetting valuation losses). That is well off the average pace of monthly pace of $68 billion of Q4, but that pace includes valuation gains from the rising dollar value of these countries euro reserves. [...].

Yet, as we all know, long-term Treasury bonds rallied and Treasury yields fell in January. Not very good supporting evidence for thesis that Asian central bank demand has helped to keep Treasury yields low.
[emphasis added-JRM]

I think it is more likely that there was a fair amount of disguised central bank buying of dollar assets.

And it is also quite likely that central banks built up their bank accounts in q4 - and probably more so in December than in October and November. If that is true, then central bank purchases of US debt securities may not fall off in January even though the pace of reserve accumulation clearly fell off. Look how long it took Japan to put all the dollars it bought at the end of 2003 and in early 2004 to work.

Reserve accumulation by these 11 banks tracks overall purchases of US debt surprisingly well in the fourth quarter. [...] Obviously, there are some private purchases as well, and not all of the central bank's increase in overall reserves went into the purchase of US securities. Some went into euros, some went into bank accounts. On the other hand, there are also more than 11 central banks in the world.

So score one for Bretton Woods 2.

...Reserve accumulation does not need to provide the financing the US needs every month for the basic thesis that reserve accumulation is providing a key source of financing for the US to hold. It may matter more in some months than in others. In January, it seems quite likely that European (and maybe Canadian) private investors picked up the pace of their purchase of US assets - presumably because they figured the dollar had fallen about as much as it was going too. The repatriation of corporate profits previously held in [say] euros to exploit the US tax holiday no doubt generated some flows as well. Pension funds are being pushed to hold more long-term bonds, creating some "real money" demand for longer-term Treasuries.

The phrase, "engine of the world economy" or "driving the world economy," or "stimulation of the economy" (global or domestic) is a common term of art in journalistic treatment of trade and business cycles. Your humble correspondent proposes to explain what this sort of talk means, or should mean.

Despite a generation of academic and political repudiation of Keynesian economic theory, journalists and legislative analysts alike employ multipliers when trying to ascertain the effects of tax cuts and transfers associated with deficits. Some of this comes from long experience; some of it is statutory, such as the recent CBO projections of federal deficits (The CBO projections often include footnotes explaining that the official figure on the table ignores things that are known to be so, like the additional $380 billion that the prescription drug package contributed to future deficits, or the costs of the War in Iraq).

Moreover, when writers speak of "driving the economy," they typically refer to demand. There's a supposition that deficits drive the economy, for all the campaign rhetoric about personal virtue. So, for example, the US population, by spending copiously on global output, has been stimulating economic growth in the rest of the world when domestic demand was inadequate; while our capital markets have furnished ample investment opportunities to refinance those burgeoning current account deficits. I think this is foolish.

The reason it's foolish is that it's so obviously unsustainable. The current account deficit cannot continue to grow relative to GDP forever, and there's no reason why people would-in essence-give us an everlasting stream of a trillion dollars worth of free goods unless they expect something in return. Likewise, there's a colossal irony that the same academics who argue that Keynes was a satanic fool also claim that our imbalances are simply a sustainable intertemporal substitution of consumption for hot money.

No, Dear Readers, let's contemplate what really drives the economy. Everyone knows there are historical periods when certain types of economies boom, while other times stagnate. Then, occasionally, the roles switch. What causes this is technological change. When the marginal revenue product of labor rises, the demand for labor increases; wages tend to increase; hours worked tend to increase; and gradually, should this persist, progressive social change occurs. Women, traditionally sequestered into crowded labor market segments, are "allowed" into higher-paid segments. Income distribution among workers becomes more equal, while labor's share of the gross national income (GNI) increases as well.

It seems, therefore, that policy makers are well-advised to consider methods of increasing the marginal revenue product (MRP) of labor. Education is one method, albeit with a mediocre track record; another is investment in transportation infrastructure. Generally speaking, however, the key technological change that increases the MRP of labor is a general decrease in the price level for capital goods. If plant and machinery becomes less costly to rent and operate, then the MRP that capital must yield in order to be utilitized, decreases-which means that the demand for capital increases, and with it, the demand for labor.

Over the short run, returns on capital tend to skyrocket when the central government launches public works projects financed with deficits; over the long run, however, multi-factor productivity growth is much more decisive. In the famous study for which he won the Nobel Prize in Economics, Robert Solow proposed that economic output per worker was a function of capital and technology; saving increased the rate at which capital accumulated, but also hastened the arrival of the point where capital depreciation was so large it devoured all of saving. Trevor Swan and Solow's famous classical growth model concluded that over two thirds of productivity growth over a long, long period of research was caused by improvements in technology-now abstracted as "multifactor productivity growth."

Subsequent researchers were puzzled by the fact that rich countries, including those with low saving relative to GDP, still tended to grow much faster than the "exogenous growth" model said they should. Some proposed that technologically advanced countries benefited from spillovers, in which a technical innovation tended to increase the returns of prior technical investment (as, in a society with lots of fax machines, each additional fax machine is more useful than a society with only two). Assuming spillovers caused increasing returns to scale of investment, however, neglected the importance of efficiency, good governance, and deep markets. It also made some absurd assumptions about the importance of spillovers, without regard to the underlying technology: in an extractive economy, spillovers from technology are few, and discontinuous. In an economy like New York City's, spillovers may be significant, but there is also an element of creative destruction as well.

Another time we need to address the shortcomings of the endogenous growth and exogenous growth models, but in the meantime, I'd like to point readers in the direction of David Romer's Advanced Macroeconomics (McGraw Hill); this is among the most common econ textbooks I've seen, and chapters 1 and 3 are devoted to these models. The New Growth Theory, AKA endogenous growth, is attributed to Paul Romer, Gene Grossman, and Elhanan Helpman; the latter two published an article entitled "Innovation and Growth in the Global Economy" (MIT Press), and I probably need to post about that another time.

However, I want to conclude this post on the following point: if the USA were "driving the global economy," that would mean precisely this: that individuals and institutions in the USA were furnishing the world with technologies that either decisively increased MFP growth abroad, or else, sharply increased capital productivity.