Guest post: The Crisis as a repercussion of global imbalances, by Peter Dorman

Peter Dorman wrote this piece in 2009 shortly after the financial implosion and has recently revised it. While I agree with almost all of what he has to say, one comment seems to me pertinent: The global rebalancing which Peter mentions, toward the paper’s end, is (a) uncertain and, to boot, (b) certain, if it happens, to prolong the Crisis ad infinitum. Why? Because, as I keep arguing in the context of my Global Minotaur, our irrational global order simply cannot grow in a balanced manner, unless forced to do so by political intervention at the global level. Or so me thinks…

5 thoughts on “Guest post: The Crisis as a repercussion of global imbalances, by Peter Dorman

  1. An interesting paper but I disagree with the bulk of what is written when it comes to trade-related money flows.

    In one of Mr. Dorman’s opening statements he writes: “…the US current account deficit… had reached 6.5% of GDP and was being financed almost entirely by dollar reserve accumulations of foreign central banks.”

    What does Mr. Dorman mean by “financed”? The fact is that the US trade deficit is not, and never has been, “financed” by foreign central banks accumulating reserves. When for example an American buys a German car for say US$40,000, the Bundesbank may end up with those US$40,000 in its US$ account at the Fed. This could be the case to the extent one were to ignore the FX market and assume that the German car manufacturer had exchanged those US$ for Euros (previously DM) directly with the Bundesbank. To say from there that there has been some form of Bundesbank “financing” is operationally wrong. Instead, a local US bank provided the financing to buy the car in the first place. Alternatively, the buyer drew down on his or her existing account at some US bank. The end result: an American ended up with a vehicle and Germany as a whole ended up with a financial asset (the US$ dollars). There is no “financing” per se…

    The follow on detailed explanation that Mr. Dorman provides is equally fuzzy. I copy a key segment and provide related comments.

    Mr. Dorman: “Currency recycling refers to the exchange of deficit for surplus currencies. Country A, let us say, runs a current account deficit (CAD) with country B. There is a net flow of A’s currency to B.”

    Comment: Technically, this is not so… A’s currency never “flows” to B. In fact, unless paper cash or coins are carried in a suitcase, A’s currency never leaves country A.

    Mr. Dorman: “Recipients of this currency take it to B’s central bank (CB) to exchange for their own.”

    Comment: Not necessarily. It could just be exchanged via the FX market without the CB having to intervene directly.

    Mr. Dorman: “Now excess reserves of A’s currency temporarily materialize at this bank.” (Mr. Dorman when he writes “bank” must be referring to the CB at B).

    Comment: This is misleading. “Reserves” is a fancy name for money at the US Federal “Reserve” Bank. So let’s assume country A is the US. There is a “reserve requirement” in that country as we know. This requirement is rooted in the need for banks that have deposits to have in parallel some cash at hand in case depositors wish to take out hard currency. Assume that the reserve requirement is 10%. The reserve requirement means that banks must hold in their vaults cash equal to 10% of the value of their deposits, or more likely they must have a 10% credit for that same amount at the Fed. So, if a bank has a client with a US$40,000 deposit, the bank must have US$4,000 in a “reserve” (a.k.a. “checking”) account at the Fed. When country A (say the US) imports a car worth US$40,000, all other things equal, the PRIVATE BANKING system in A will need to hold less “reserves”, referring to the US$4,000, and only necessarily so in this very peculiar example that Mr. Dorman describes in terms of direct CB intervention. However, in so far as the US$40,000 are concerned, country B’s CB (the Bundesbank) may indeed end up holding the US$40,000 in its “reserve” account at country A’s central bank (the Fed). Importantly, this US$40,000 is not “excess reserves”. The US$40,000 is an accounting entry resulting from the exporter in B having wanted to exchange US$ for B’s currency (in Mr. Dorman’s example). Only the US$ 4,000 can be referred to as “excess reserves”.

    Mr. Dorman: Some portion may be acquired by other individuals or institutions within B who wish to purchase assets in A; this would be an offsetting private capital flow. If private demand for A denominated assets is not sufficient to deplete the excess reserves, two main possibilities present themselves. The CB of B could sell these excess reserves on the market in order to obtain other currencies, driving down the value of A’s currency—and potentially contributing to a market correction for the current account imbalance. Alternatively, the CB could retain these reserves, holding them in the form of A-denominated assets. In other words, the CB could supplement private capital flows to A with a public capital flow.

    Comment #1: To a minimum this is not easy to follow. The bottom line main alternatives for the CB at B are: 1) keep the US$40,000 at the Fed’s “checking” account; 2) transfer the US$40,000 from the Fed’s “checking” account to the Fed’s “savings” account (i.e. buy US Treasuries), or exchange the money for some other US$ denominated (financial) asset; or 3) sell those US$40,000 in the FX market and obtain some other currency.

    Comment #2: The reference related to the value of A’s currency paints an incomplete, and I believe incorrect, picture. When country A imported (generating demand for a product in country B and therefore generating demand for country B’s currency), all other things equal, there would have been upward pressure on B’s currency and downward pressure on A’s. One way to counter that would be if, separately, there were an equivalent demand for a product of country A… and indeed it could be a financial product. However, it would have to be a separate and additional transaction. In other words, the CB at B just switching the money that the vehicle sale generated from the Fed’s checking account to the Fed’s savings account wouldn’t cut it.

    Lastly, Mr. Dorman references the national income (GDP) formula to drive his point. I believe that the most insightful analysis that deals with this formula is that generated by the late Wynne Godley in his Sectorial Financial Balances Approach. This is not a theory, it is pure accounting and double entry basic maths. The two GDP formulas are re-arranged as follows: (M – X) = (G – T) + (I – S). In words: if a country is importing more than it is exporting (i.e. the Foreign Sector is running a surplus), then it must be the case that one or both of the other two sectors in the economy (the Domestic Government Sector and/or the Domestic Private Sector) are running a deficit, such that the equation balances out, and in order to maintain incomes constant.

  2. “Or so me thinks…”

    And we think ,you think well

    And what was that with Olli Rehn? Is he wanted in Hollywood and wants to have more experience before he appears as a comedian?

    Me go laugh now.

  3. Very heavy going but Ill try and pick out a few points.

    “The sins of deregulation,
    dishonesty and incentives that reward reckless behavior were apparently universal, to the extent that, for many
    observers, the economic crisis was a financial crisis in all significant respects.” this is extremely shallow analysis and this shallow analysis compromises the article. Dorman needs to understand why participants were dishonest and where were the incentives were coming from otherwise things get religious and words like “sin” start getting used to fill the gaps in understanding.

    And other massive mistake “but the underlying model is one in which the primary forces are inertial, behavior is largely
    governed by convention, and the fog of uncertainty prevents the attainment of an equilibrium end-state” – it is impossible for markets to be unstable over the medium to long term. Impossible. To say the system is out of balance is the same as saying *no* participants *ever* see strategies which could make them billions. There is always someone betting against the tide, always someone looking for a gap in the market, always someone looking to exploit undervalued assets etc etc.

    I know what Soros says and it is obviously incorrect. Just use Soros himself as an example. He has made his money by betting against the market. It is people like Soros who create the medium and long term stability.

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