Macro Perspectives on Global Liquidity: How Chinese Farmers and Oil Sheiks are Subsidizing American Consumption and its Implications
February 23, 2007
If you were an economist arriving from Mars and looked at capital flows around the world, you would be very surprised by the patterns you observe. Ex-ante you would have expected the wealthiest countries to be exporters of capital as return on invested capital should be higher in developing countries than developed countries. The UK was a net exporter of capital when it was at the height of its power. However, a glance at actual capital flows shows that the US is an importer of capital with a current account deficit nearing $1 trillion dollars and 7% of GDP.
Where the flows are coming from and what assets they are invested in is just as interesting. US corporations are actually net exporters of capital. The current account deficit is caused by consumer and government consumption. Almost all of the deficit is with China and the Middle East, which to date have been investing in treasury bills. Chinese citizens have an extremely high savings rate, which when combined with the Chinese government’s desire not to let the Yuan appreciate against the dollar, means that China has been buying hundreds of billions of dollars of treasury bills. Similarly, the Middle East is awash in cash given the increase in the price of oil and the low extraction costs. As domestic consumption has not and probably cannot increase beyond certain levels without unleashing inflation or the money getting wasted as it was in the 1970s, most of that excess cash has also been invested in American treasury bills.
As American treasury bills are not yielding very much and as the Yuan and Middle Eastern currencies are reasonably expected to increase relative to the US dollar, you could expect them to make little or negative returns on their US investments. In other words American consumers’ and the American government’s consumption are being subsidized by Chinese citizens and oil sheiks!
If any country but the US had a 7% current account deficit, alarm bells would be going off at the IMF and elsewhere. Fortunately for the US as the dollar is the reserve currency of the world and its debt is denominated in dollars, it can print as much money as it needs to cover the debt. The issue is that being the reserve currency of the world is not a given and geopolitically depending for funding on countries whose loyalty is dubious at best is risky. Optimists will point out that China and Middle Eastern countries have to continue to buy treasury bills and cannot sell their holdings if only to prevent the dollar from collapsing and generating significant losses on their investments. This is not a good argument. For where it to happen, the US would undoubtedly have lost its reserve currency status.
For capital flows to realign four things need to happen:
- Consumer savings needs to increase in the US
- Government savings needs to increase in the US
- Consumption needs to increase in China
- Consumption needs to increase in the Middle East
How fast this happens will determine the outcome. Historically, such adjustments were rapid and led to massive currency depreciations and recessions (think of the 1998 Asian currency crisis). A year ago, I was extremely bearish about the US economy as I felt we could be entering a perfect storm.
Specifically, I thought global liquidity would collapse as:
- Short term interest rates rose in Japan ending the Japan carry trade were people would borrow in Yen at a 0% rate and invest in dollars and dollar denominated assets yielding much more than that
- Short term interest rates rose in the US
- As baby boomers started to prepare for retirement, I expected the American savings rate to start to increase
- I expected US consumption to start declining as homeowners on variable rate mortgages faced higher bills leading both an increase in foreclosures, supply of houses, decline in prices and a further decrease in consumption
In addition, the yield curve was inverted, which was usually a harbinger of a recession to come.
I was wrong. Interest rates rose in Japan and the US. There was a real estate correction in the US. Yet throughout the period liquidity remained high. The world is still flush with cash.
Peter Thiel, a brilliant friend of mine who was founder of Paypal and now runs a macro hedge fund called Clarium thinks he knows why – and I agree with him. China also has a current account deficit with the Middle East so arguably all of the excess liquidity in the world is coming from the Middle East. As long as oil remains above $40 – and there are a lot of reasons to believe it will remain around $60 for years to come – the global liquidity glut is not about to disappear.
As both China and Middle Eastern countries seek higher returns on their investment you can expect even more money to flow into venture capital, private equity, hedge funds and real estate – despite the fact that returns have been declining and that people have been predicting a collapse for a long time.
This is why you are seeing frothy valuations for assets around the world:
- Startups are raising money at high valuations
- Ever larger private equity deals are happening
- Hedge funds keep pooling ever larger sums of cash
- Real estate prices are still increasing globally
So what does this all mean? If you are an entrepreneur trying to raise money – this is a very good time to do so! The fact that oil prices are likely to stay high suggests that the liquidity glut is likely to endure for quite some time, but you never know so take the money while it’s available! From an economic perspective, I think this explains cleanly why we have seen asset price inflation without seeing real core inflation. The last time this happened was in 1978-1979 during the last oil shock. Peter’s contrarian thinking is that this suggests that short term interest rates are not going to go down anytime soon. The asset price inflation and excess global liquidity suggest that central banks should probably have a more monetarist stance and if anything might have to increase short term interest rates. Before Volker the Fed was essentially saying: “Inflation is 10%, our interest rates are 10%, we are neutral.” Volker came in and essentially said “inflation is 10%, but asset and monetary inflation is so much higher that interest rates should be 20%.” He brought core and asset inflation under control at the cost of a severe recession that set the stage for the expansion that has essentially gone unabated ever since except for a few very mild recessions.
In other words, Peter’s contrarian stance is that the yield curve is going to become even more inverted as short term interest rates increase – at least in countries which are paying attention to liquidity growth like the UK and Japan – while long term interest rates remain low given the excess global liquidity. This story’s most likely outcome is a severe recession.
It’s interesting that while I am probably the most optimistic person I know in terms of life, humanity, geo-political outcomes and our long term success as a civilization, I am such a pessimist the US economic prospects in the short and medium run. For once, I really hope I am wrong!