Tuesday, December 30, 2008

Terrific Article – Setser’s “The Collapse of Financial Globalization…”

I want to share an article by Brad Setser which can be found in its entirety here: The Collapse of Financial Globalization…

Below, I have assembled what I feel to be the key statements. He does a terrific job of explaining cash flows through the Shadow Banking System, and how those flows have stopped. He also demonstrates how our nation’s debts have been propped up for as long as they have and just how fragile that balance of international flows is. To me this is more evidence of our nation’s and now world’s dollar Ponzi scheme. It’s all a Madoff style house of cards where once the flow of funds gets interrupted, the entire scheme can and will come crashing down.

While you may not fully understand Setser’s work at first glance, give it some thought and that house of cards will become evident. I’m continuing my work to try to make this easily understandable – it is my contention that our banking and monetary systems are the root cause of the problems. They have combined to corporatise and corrupt every step of our political system (italics are mine for emphasis):
The collapse of financial globalization…

Posted on Monday, December 29th, 2008

By bsetser

The last six months — if not the last year — logged what felt like a decade’s worth of financial news. So perhaps it isn’t surprising that swings that normally would attract an enormous amount of attention have gone almost unnoticed. Like the near-total collapse of private capital flows.

Both private capital inflows to the US and private capital outflows from the US have fallen sharply. They have gone from a peak of around 15% of US GDP to around zero in a remarkably short period of time…

The fall in private flows over the last four quarters has been much sharper than the fall in the US current account deficit. The current account deficit continues to hover around $700 billion (5% of US GDP). Financial globalization — the growth in private cross-border flows, and associated rise in private inflows and private outflows — doesn’t seem to have been as central to the ability of the United States to sustain large current account deficits as some thought back in 2004 and 2005.

…But even if “private” Treasury purchases since mid-2007 are counted there still would have been a stunning fall in private capital flows. Direct investment flows have continued. Other financial flows though have largely gone in reverse, with investors selling what they previously bought. In the third quarter foreign investors sold about $90b of US securities (excluding Treasuries) and Americans sold about $85 billion of foreign securities. And the reversal in bank flows on both sides (as past loans have been called) has been absolutely brutal.

This sharp fall has bearing on the bigger debate over the role global capital, global savings and foreign central banks played in helping to to create the conditions that allowed US households to sustain a large deficit for so long — and whether American and other policy makers should have paid more attention to the risks that came with the surge in foreign demand for US financial assets earlier this decade.

…Think of the process this way. Suppose a US bank lends a billion dollars to a bank in London that lends that money to a hedge fund domiciled the Caribbean that buys a billion dollars of US securities. That chain results in an outflow and inflow, but the outflow just financed the inflow — it doesn’t help to finance the current account deficit. By contrast, China’s purchases of Treasuries and Agencies reflect in large part China’s current account surplus — not Chinese banks borrowing from US banks. They certainly help to finance the US current account deficit.

I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system.

It was a largely unregulated system. And it was largely offshore, at least legally. SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing. European banks that had a large dollar book seem to have been doing much the same thing. The growth of the shadow banking system consequently resulted in a big increase in gross private capital outflows and gross private capital inflows.

Those private flows have now disappeared, or even reversed. They actually started to disappear back in August 2007. That didn’t keep the US from continuing to run a large (5% of GDP) current account deficit. The fall in private flows has been far sharper than the fall in the current account deficit.

Why didn’t the total collapse in private flows lead financing for the US current account deficit to dry up? That, after all, is what happened in places like Iceland — and Ukraine.
My explanation is pretty straightforward.

Central banks were the main source of financing for the US deficit all along. Setting Japan aside, the big current account surplus countries were all building up their official reserves and sovereign funds — and they were the key vector providing financing to the deficit countries.

And when (net) private demand for US assets fell, official flows picked up. As I noted earlier, private purchases of Treasuries after June 2007 are almost certainly really official flows. If those purchases are added to recorded official flows, total official flows over the last four quarters of data (q4 07 to q2 08) now almost match the current account deficit.

…Central banks lent the proceeds of their swap lines with the Fed to private banks abroad, and private banks in turn repaid their maturing dollar debts — so the swap lines financed the unwinding of existing US loans to the rest of the world. Call it facilitating the unwinding of some of the legacy of the excesses of the past few year. Or call it a new wave of financial globalization, one led by the central banks…