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Background Report on The Roubini-Setser Predictions

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									Background Report on The Roubini-Setser Predictions
Nelson Paterson January 23, 2007

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Introduction

The current account deficit position in The United States has grown dramatically over the past decade and appears to be growing with increasing speed. The current account deficit in stood at 791 billion dollars in 2005 when only a decade prior the current account deficit stood at 113 billion dollars constituting a 600 percent increase from 1995 to 20051 . These startling figures have prompted considerable concern over the sustainability of maintaining of such a large current account deficit. In 2004 Nuriel Roubini and Brad Setser came out with a paper chronicling the the events which led to such a dramatic downward spiral in the currant account position, providing reasoning behind why such a current account deficits is unsustainable as well as making a set of predictions over what the impacts of this deficit will be over the next few years. The major concern Roubini and Setser have is over the ability of the United States to continue to borrow from abroad at low interest rates with such an unfavorable debt position. This is especially important considering the persistent fiscal deficit as well as insufficient domestic savings or willingness to save to cover domestic investment and additional debt. Of further concern are the implications for such a large current account deficit in relation to the sustainability of the Bretton Woods II system, which emerged tacitly through the fixed exchange rate regimes of a number of Asian block countries. They contend that it is these countries which are financing the United States current account deficit and ultimately their fiscal deficit. If this New Bretton Woods system were to break down under the current state of the US current accounts the result could spell major change in the interest rate paid on US debt which would translate to major problems for U.S. economy as they try to finance their fiscal deficit. Roubini and Setser sum up their analysis by providing two likely scenarios for the future barring a change in the current account position of the United States. Both of
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Bureau of Economic Analysis (2006), http://bea.gov/bea/di1.htm.

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these scenarios provide a particularly gloomy outlook for the U.S. economy and perhaps even the world economy in the near future. 1. “Asian central banks will continue to finance the U.S. fiscal deficit allowing for the U.S. to continue to spend more than it earns for a bit longer.” 2. “Asian central banks stop intervening on the scale needed to finance the U.S. deficit and the U.S. will have to adjust. (Roubini and Setser (2004) p.58) This background report with be focused on explaining the implications of and reasoning behind these predicted scenarios particularly in reference to the Bretton Woods II monetary system. The remainder of the report will be broken into three sections. Section two containing an analysis of the implications for the deepening of the current account deficit. Section three providing a discussion concerning the Bretton Woods II monetary system and its relationship to the U.S. current account deficit. Finally section four which will provide a summary of the Roubini-Setser predictions with regards to the over all impact on the U.S. economy.

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The Current Account Deficit

Roubini and Setser use the current account as a measure for risk in investment. The degree to which the current account is in a deficit position represents the degree to which the home country is indebted to foreign investors (savers). The indebtedness of a country, much like that for an individual provides some perspective on the ability of that country to quickly pay off its creditors and as such represents the risk associated with lending to that country. Considering lending money is not without risk the lender will demand compensation for taking on this risk. The amount of compensation will be proportional to the level of risk, which will inevitably be proportional to the level of the borrowers initial indebtedness. 2

Roubini and Setser’s primary concern is over how much longer the United States can continue to pay low levels of compensation on loans as their current account deficit puts them in the position of being the worlds largest debtor. (Roubini and Setser (2005)) They predict that this can’t continue forever and probably won’t be able to continue for very much longer. The result will be that in the short to medium term we could see interest rates rise in the United States to levels which take into account the increase in indebtedness of the United States. The consequences of such an increase in interest rates on foreign loans would be far reaching for the US economy especially as the United States also runs a fiscal deficit. This fiscal deficit is largely financed through foreign debt at low interest rates so as not to crowd out private domestic investment. (Roubini and Setser (2004)) Figure 1 shows the U.S. current account from 1960 to 2005. Prior to the 1980’s the United States maintained a roughly balanced current account position, actually running small surpluses in most years. From 1980 onward the United States persistently ran current account deficits with the exception of 1991, and these deficits accelerated in size through the mid 1990’s until present and currently stand at 791 billion. Roubini and Setser while concerned over the change in size of the of the deficit are also concerned over change in the causes of such a deficit. Over the nineteen nineties the current account deficit was a function of high domestic private investment coupled with low domestic private saving requiring firms to seek funds from abroad. In this way the current account deficit was being used to finance investment which would yield higher future income. Roubini and Setser point out that this was no longer the case come the early part of the current decade. The current account deficit was now being used to finance the United States’s fiscal deficit an ultimately consumption rather than investment. They view this as an unproductive use of funds from abroad as compared to the pervious state. Furthermore they find the use

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of the current account deficit to finance the U.S fiscal deficit to be unwise considering the instability of the current international monetary system. Critically they ask the questions about what would happen if the federal government would no longer be able borrow from abroad as cheaply as they can under the current system. (Roubini and Setser (2004))

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The Stability of Bretton Woods II

After the financial crises in Asia during the nineteen nineties began settle down there was a marked shift in the policies of the affected countries away from financing investment through external sources. These countries began to move from a current account deficit position to a surplus position and began to focus on export lead growth rather than on growth through foreign investment. However under a floating exchange rate regime large current account surplus in these countries would lead to currency appreciation. Such appreciation would be seen as undesirable for an export growth lead country and so steps began to be taken by these countries to aggressively avoid appreciation. (Roubini and Setser (2004)) As a result this block of Asian countries have ended up fixing their exchange rates to an ‘American Dollar-Chinese Renminbi’ peg. Since the Chinese renminbi is also pegged to the U.S. dollar (as part of a basket of of other currencies) these countries are essentially pegged primarily to the U.S. dollar putting the United States squarely at the center of this new currency regime. The comparison has been drawn between this current monetary system and the system which came out of the Bretton Woods conferences following world war two. (Dooley et al. (2003)) However unlike the original Bretton Woods regime Bretton Woods II is merely a tacit agreement and it is unknown how long this arrangement will last. It is in this respect which Roubini and Setser are concerned. The current account

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surpluses in these Asian countries are directly financing the current account deficit in the United States under this regime which are leading to artificially low levels of risk compensation via the interest rate. If this system were to break down under the present position of the current account deficit the result could force an end to cheap current account and fiscal deficit financing. Roubini and Setser had predicted that Bretton Woods II could fall by the end of 2006 and while this has not happened other predictions have suggested that the monetary system could last anywhere from another year to the rest of the decade. (Roubini and Setser (2005)) Roubini and Setser point to five major reasons why we should expect a collapse in the monetary system.

1. “The intrinsic tension between the United States’s growing need for financing to cover its current account and fiscal deficits and the large losses that those lending to the U.S. in dollars are almost certain to incur as part of the adjustment needed to reduce the US trade deficit” 2. “The significant internal dislocations in the U.S. associated with rising trade deficits, along with the distortions in the allocation of U.S. investment stemming from the combination of cheep central bank financing and the over valued dollar.” 3. “The significant burden financing the United States imposes on Asian governments and the risk it poses to the stability of Asia’s domestic financial system.” 4. “The European Central Bank will reduce pressure on Asian central banks by building up its dollar reserves though large scale intervention. Politics matter: France and Germany will are not willing to bankroll President Bush’s foreign or domestic policy choices.” 5. “The institutional infrastructure behind the “Bretton Woods II” system is too week to support the pace of dollar reserve accumulated required to sustain the system.” (Roubini and Setser (2005) p.3-4)

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Conclusion

Roubini and Setser predictions are designed to point out just how unstable the United States’position is. Their double deficit position coupled with an unstable international monetary system should be a cause for major concern. Higher interest rates caused by increased risk could have disastrous consequences for the ability of the United States to cheaply finance their fiscal deficit as well they could potentially push the U.S. into a recession as the cost of investment rises. Turning back to the two scenarios described at the beginning of this report we see that neither predict positively for the future. Under the first scenario the United States is able to continue to run current account deficits in the short term. However, they will do so at a cost because once the system does become unsustainable their debt position will only be that much worse causing lenders to demand larger compensation for their risk. Under the second scenario the value of the US dollar would surly decline and interest rates would have to rise to attract enough funds from abroad as well as domestically to pay for the US fiscal deficit. The underlying tones of the Roubini-Setser predictions are that the U.S. current account deficit is not sustainable and that steps must be taken to lower the deficit if the U.S. wants to continue to be able to enjoy low interest rates on external as well as internal debt.

References
Dooley, M. P., Folkerts-Landau, D., Garber, P., September 2003. An essay on the revived Bretton Woods system. NBER Working Paper 9971. Roubini, debtor: N., The Setser, B., August of the 2004. U.S. The external U.S. as a net NYU,

sustainability

imbalances.

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http://pages.stern.nyu.edu/nroubini/papers/Roubini-Setser-US-ExternalImbalances.pdf. Roubini, N., Setser, B., Feburary 2005. Will the Bretton Woods 2 regime unravel soon? The risk of a hard landing in 2005-2006. The Symposium on the “Revised Bretton Woods System: A New Paradigm for Asian Development?”, Federal Reserve Bank of San Francisco and UC Berkeley.

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Figure 1: U.S. Current Account 1960-2005. Source: Bureau of Economic Analysis (2006), http://bea.gov/bea/di1.htm.

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