A "scary graph" terrorizes the econoblogosphere

What happened to the foreign appetite for U.S. assets? Do the words "Wile E. Coyote moment" mean anything to you?


Andrew Leonard
November 29, 2007 2:24AM (UTC)

By the third time this morning that Brad Setser's "scary graph" had flashed before my eyes as I made my way through the econoblogosphere, I knew it was time to start paying attention.

Setser, an economist at the U.S. Treasury Department during the Clinton administration, focuses obsessively on international capital flows. It's a complicated subject; following the ins and outs of his detailed analysis is not for the timid of heart. But the bottom line expressed in the chart is simple: Based on Setser's interpretation of Treasury Department data, private foreign demand for U.S. assets has come to a screeching halt. (Setser uses the term "sudden stop," which has its own specific meaning in the world of emerging market economics, but we'll leave that discussion to the card-carrying economists.)

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Look at the graph. Sharp drops and equally sharp surges have been reasonably common since 2000, but nothing compares to the plunge that started in July. What else happened this summer? The subprime mortgage meltdown precipitated a major credit crunch.

What does this mean? Naked Capitalism's Yves Smith summarizes the basic economic principle at work:

...the general premise [is] that trade deficits, like the one the U.S. has been running for a very long time, need to be matched by surpluses in the capital account, meaning in colloquial terms that our trade deficits are funded by foreign investment of various sorts, be it in Treasury securities, stocks, real estate, or factories.

Economists talk about this "need" for balance with the same reverence physicists use to invoke the laws of thermodynamics. One way or another, the arithmetic has to balance. If foreign investors don't want U.S. assets, but the U.S. keeps running a trade deficit, something has to give. Right now, that something is the dollar.

But a declining dollar, in turn, poses a huge problem for the non-private, or "official" sources of capital inflows that are continuing to prop up the U.S. current account deficit -- such as China or the oil states busy bailing out U.S banks. Central bankers are watching worriedly as the value of their huge dollar-denominated foreign reserves diminishes by the hour, but they are paralyzed by the prospect that if they too stop buying U.S. Treasuries and the like, and attempt to diversify their holding, the downward pressure on the dollar will get worse. And that's where Wile E. Coyote, about to look down, joins the party.

Setser has been warning for a long, long time that the U.S. would eventually have to pay the price for not keeping balanced books. The scary part of his scary graph is its very plain hint that the collection agency is knocking at the door.

But today, Wall Street isn't worried. All it needed was just a hint that another rate cut is coming (which in itself one would rationally think should be taken as a sign that the economy is in real trouble) and investors were off to their races -- the Dow Jones industrial average surged 331 points -- one of its best days of the entire year.

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Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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