Brad Setser is a senior fellow for international economics at the Council on Foreign Relations where he works on macroeconomics, global capital flows, and financial crises. Brad also served as a deputy assistant secretary at the U.S. Treasury Department from 2011 to 2015 where he worked on Europe’s financial crisis, currency policy, financial sanctions, commodity shocks, and Puerto Rico’s debt crisis. Brad joins the Macro Musings podcast to discuss global economic imbalances and why we should care about them.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Brad, welcome to the show.
Brad Setser: Thanks so much for inviting me.
Beckworth: Well, it's great to finally meet you in person. I've interacted, seen you online, I think, almost a decade now, so, it's neat to finally meet you, and you've put up with my bantering online. So, it's real gracious of you to come on, and I know, listeners have actually requested, you're one of the people they've requested many times, so, I think they'll look forward to hearing from you. And, I always ask my guests, how did you get into economics and into macro economics in particularly? What's your story?
Setser: I think I am a case study for how the first job you take matters. So, I did a PhD, actually, in international relations. I knew I was interested in public policy, and my very first job out of grad school, first real job, was a staff economist in the International Affairs Department of the US Treasury. I started in 1997. I guess I was hired to track the trade balance. That was sort of my narrow little portfolio, but with the Asia crisis unfolding, I chased the hot topic. I got myself on the Asian financial crisis task force, and then I got myself on a financial architecture working group task force, which was distilling the lessons from Asia for all emerging economies.
Setser: And, in some sense, that put me on a trajectory where I've remained; the basic topics of watching trade flows, watching financial flows, which I really hadn't paid much attention to until I started working on financial crises at the Treasury, and thinking about debt restructuring issues have shaped most of my subsequent work.
Beckworth: Well, that's interesting. So, it was all about timing there. Just in time for the emerging market crisis.
Setser: Yeah. Yeah, if I'd come two years earlier, I might have been bored and left and done something else. It really was very fortuitous.
Beckworth: Now, you worked with Nouriel Roubini later. I know he was at Treasury, too, briefly. Did you guys ever overlap there, and then work together afterwards?
Setser: Absolutely. As a byproduct of my work on the financial architecture taskforce, I actually got tasked with being Nouriel's Treasury minder, as he was writing the financial crisis chapter in the economic report of the president. He was at the CA, and I had very clear instructions from high levels of the Treasury Department, not to allow Nouriel to unilaterally make policy. So, I was a rather severe editor, and I guess I succeeded, because he concluded, at the end of his year at the CA, that he wanted to come over to the Treasury, and he was actually my boss at the Treasury for a year.
Beckworth: Okay. Oh, very interesting. And I think that's where I first saw you soon after that, when you and Nouriel were writing together, you had some interesting pieces on global economic imbalances, we'll talk about that in a minute, but you developed a very particular set of skills. You were, again, this guy who looked at flows, who looked at balance sheets, the go to guy, where the treasuries go, and where they are coming from. Very interesting. And you develop that at Treasury also working with Nouriel. Now, you were also an early blogger. You're one of the early cutting edge bloggers back before it really became a hot thing. Is that right?
Setser: I don't know if we're like Tyler Cowen-esk early.
Beckworth: Come on, you're avant-garde. You were ...
Setser: Nouriel ... I mean, actually after working for Nouriel at the Treasury, I did spend a year and a half at the IMF, so I did some behind the scenes work, and then I agreed to write a book with Nouriel. And when the book came out in early 2004, more or less we finished it in 2003, and while I was waiting for the book to come out, and to be honest, waiting for the 2004 presidential elections, Nouriel offered me a little bit of money to write a blog, like research assistant money, not a salary, to write a blog for his global crisis homepage, which was the successor to the Asia crisis homepage. And so, I started a few tentative steps into blogging in 2004, and then I committed to it more seriously in 2005.
Beckworth: Well, that's pretty early though in the blogging...
Setser: I don't know-
Beckworth: ...historical timeline. I mean-
Setser: In the historical timeline, yeah, we were ... Back in the days of calculated risk, and some of the Marginal REVOLUTION. We were in the simple old blogs based on words with very limited grasp, that kind of era.
Beckworth: But it was nice, because I still remember. I mean, I was ... In fact, I worked at Treasury briefly in international affairs too, and I was reading Nouriel's work, and then I went to academia after that, so I remember following your work at that time, but it was one of the few blogs that was solely dedicated to macro issues. I mean, you're right, Marginal REVOLUTION, my boss was blogging way back when ... Brad DeLong was there too, I guess, but, I think, the Freakonomics, more of the applied econ blogosphere was probably the more popular form of blogging. So, you were one of the few macro bloggers. Anyways, I have a strong connection to your work going back then.
Beckworth: Okay. Moving forward, though. And more recently, you worked at the US Treasury departments, and also at the National Economic Council. So tell us about them. You worked on Europe's financial crisis. Again, it looks like you had great timing coming in in the midst of a number of developments. So, tell us about that recent experience.
Setser: Well, actually, I was semi-afraid because it took six months for all the paperwork to clear before the Obama administration. So, when I joined the Obama administration, I was afraid that the US financial crisis had been solved before I had a chance to contribute. Because, the key events were really ... They were all very front loaded in the timeline of the Obama administration; the spring of 2009. And that's when I was ... I knew I had agreed to join the administration, but I was being investigated, and it took a while to find the right salary slot. It is complicated, more complicated than I realized. And then, when I joined, actually, I thought I was going to be working mostly on China and China currency issues, but then, in the fall, I think, of '09, certainly in early 2010, Greece really exploded onto the scene. And so, I ended up working very extensively inside the Government, both on the NEC side, and then to the Treasury side, on Europe's financial crisis as it unfolded, and I think that was probably the bulk of my day to day work.
Setser: And then, in the second term, after Mario Draghi's "whatever it takes", and some of the commitment by Merkel to support a bigger backstop through the ESM, and, at some point, the markets turned, and Italy and Spanish government bonds yields started to fall, and Europe continued to be depressed and lacking demand, but defaults, major defaults, systemic defaults, big bank collapses, no longer seemed imminent. And so then I worked on a broader set of issues, including some work on financial sanctions, which has turned out to be, with hindsight, probably more interesting than I recognized at the time.
Beckworth: You also worked on Puerto Rico's debt crisis, which is another very topical issue. So, you had a very rich experience, and very fascinating work, and, for those of us who were following your work online, we noticed that void in blogging when you went to work for the government. Now you're back online, so it's fun to follow you again. But let's move forward and talk about some of the topics you work on, have worked on, and continue to work on, and one of the big themes, I think, if you look across your work, is global economic imbalances. So, you wrote a lot about this before 2008, you're writing about it now. It's changed some, who the key players are, what's happening, but give us the bird's eye view; what are the global economic imbalances, who are the key players, why should we care about them?
Setser: Sure. The basic insight between all of the discussion around global economic imbalances is that, if one set of countries is running a large current account surplus, there, by definition, will be another set of countries running a large current account deficit. The world as a whole, setting aside some data issues, doesn't ... Its current account has to balance. The current account is the trade deficit plus the net flow of interest income and dividend income, but, for most countries at most stages in time, setting aside tax havens, it tends to be fairly close to the trade balance. And with the trade, is sort of obvious, if one country is running a surplus, another country in a two country world has to run a deficit. An imbalance, first, is a indication that there is a large surplus on one side and a large deficit on the other. And, the constant over the past 20 or so years has been a relatively large US deficit, and when I first started working on imbalances, the concern was the size of the US deficit and its persistence.
Setser: In 2004, I think the trade deficit and the current account deficit were in the five-ish percent of GDP range, so, bigger than they are now. And, at the time, and this has definitely changed, the big surpluses that are on the other side of the ledger, were typically found in emerging economies. Not exclusively, Japan always ran a current account surplus, but back then, Europe was much closer to being imbalanced than it is now. And so, there was talk about the uphill flow of capital; poor countries were financing rich countries, which raises a set of issues and puzzles. And, obviously, this was the time when the big flow from China to the United States developed. When I started, China's current surplus was only about 100 billion, which was seen as big at the time, but it was modest compared to the 350 billion surplus that China ended up running in 2007. So, it was a period when China's surplus kept getting bigger, Chinese bond purchases kept getting bigger, and China's surplus came at the same point in time that the oil exporters were running a really big surplus, which conceptually is a little odd.
Setser: China has an oil importer, it's not heavily endowed with natural resources, you would think its current account would not track that of the oil exporters, but because of the particular circumstances of that time, large surpluses developed both in the oil exporters who are benefiting from China's commodity demand, and in China itself. And that was the configuration running up into the 2007, 2008 when the US financial system started freezing up because of mortgage risk, and the collapse in US demand led the US deficit to start to fall.
Beckworth: Right. Let me set it this way; a current account balance also can be seen as the amount of savings a country has, whether they're saving more than they spend. So, if a country is running a current account surplus, they have excess savings, is that right?
Beckworth: So, in other words, China had all this excess savings flowing overseas, and it found its way into the US, the Middle East as well, and you mentioned the emerging markets were the big ones prior to 2008, what's happened since the crisis? Has anything changed in terms of the big savers of the world?
Setser: Well, I think two important things have changed. China still saves an incredible share of its GDP. Its national savings rate is as close to 45% of GDP, which is just off the charts.
Beckworth: It's mind blowing compared to what we do in America.
Setser: I mean, it's shockingly higher than Norway, which is considered the model of fiscal prudence when managing its oil wealth has ever achieved. The only country that has matched that on a sustained basis, that I know, is Singapore, which is a small city state organized around channeling and building up national wealth. To have China match that on a global scale is extraordinary. However, before the global crisis, China's savings rate was a little higher, and China's investment rate was a little bit lower. So, China was running current account surplus that got close to 10% of its GDP. It was higher than 10%, and then the data was revised, and I think it's not lower on an ex post basis. After the crisis, China did a big domestic stimulus, started the credit boom, and then a macro sense that raised the level of Chinese investment. And so, by raising the level of investment, China used more of its savings at home, and has had less to export to the world. So that's, I think, change A.
Setser: Change B ... Actually there are probably three changes. Change B is Europe saw a collapse in demand, and Europe has structurally moved into a large current account surplus, which wasn't the case before; the Spanish housing boom, the Irish housing boom, France's ... It wasn't quite a housing boom, but France generated at a decent amount of demand prior to the crisis. The Dutch had a little bit of a housing boom. All that supported demand inside the euro area before the global crisis, and nothing comparable has emerged as an engine of internal demand inside the Euro area. So, the euro area has become a big savings exporter in a way that it wasn't before.
Setser: The third factor is that the, and I think importantly there, the distribution of the world's current account surplus has largely shifted from emerging economies to advanced economies. And, within that story, Korea looks a little bit more like Europe. So, there are parts of Asia that haven't followed China, and have seen their current account surpluses go up. Those tend to be the more advanced economies in Asia. And then finally, the US current account deficit fell to about little under 3% of GDP. Most of the fall took place during the crisis, and then after the crisis, that adjustment has, by and large, been sustained. Initially, it was gas sustained, because the US had a modest recovery. And so, the level of demand in the US wasn't exceptionally strong, and the dollar was relatively weak up until 2014. Since 2014, the mechanics of the fall in the US deficit have shifted, and the oil boom has played a much, much bigger role relative to the falling demand and the shift in the dollar. So, the non oil trade deficit is actually back up to where it was before the global crisis, but our oil deficit has essentially disappeared.
Setser: And as a result, when you combine all that, our current account deficit is not as large relative to our GDP as it was, but I think, on both sides, the surpluses are probably a little bit bigger than they should be, particularly in Europe, Taiwan, Korea, Thailand, and the US, and maybe the UK, have had bigger deficits, and I think would be optimal.
Beckworth: So, compared to 2008 and before, have global imbalances come down? You mentioned the US current account deficit is smaller on a sustained basis. Has someone else offset that, and if not, it would suggest that maybe some of the overall imbalances have come down, or am I wrong on-
Setser: No, no, the overall imbalance has come down. The good debate is over whether it has come down enough. It is not at the sides of '05, '06, '07, but '05, and '06, and '07 were at an exceptional level. It hasn't returned to the deficits and surpluses that would have been typical amongst the major economies in the 1990s. Thailand obviously had a huge deficit going into its crisis. So, in aggregate, clearly the global imbalance, the gap between the absolute size of either the surplus or the deficit has come down. The nature of the error term has also evolved. So, structurally, we can count more surpluses around the world than we can count deficits, but there has been a fall in the aggregate imbalance. And then, there has been a shift in the composition. So, the subset of surplus countries has basically gone from being all emerging markets to a couple of emerging markets, and Europe, Japan, and the newly industrialized countries of Asia.
Beckworth: All right. So, if I'm looking at countries that run current account surpluses, is there a rule of thumb, or a number where you say, "Their surplus is getting a little too big?" Is 3% and below okay, and anything above that, or it's some other number you would ...
Setser: I mean, I think 3% is ... It's a good base for analysis. If it's above three, the odds are is that it's too big.
Beckworth: Okay. When we say too big, and we say excessive surplus, is the implication that policy is engineering this, or there's something unnatural about it?
Setser: Typically, if a surplus is bigger than 3%, it reflects some subset of policy choices, whether it is a fiscal policy that is substantially tighter than other countries' fiscal policies, which would be the classic explanation for Germany surplus, or heavy intervention in the foreign exchange market, which is holding your currency down and supporting your export sector, or in some cases, and, obviously, this gets into a much more political debate about values as well as a debate about flows, but underdeveloped social insurance systems tend to lead to higher savings, and that contributes to some large surpluses. So, Korea, for example, spends a lot less on social insurance than many other advanced economies, and that adds to its surplus.
Setser: On the deficit side, if you're borrowing a lot from the rest of the world, and in most cases, you're borrowing, a large deficit hasn't typically reflected big inflows of foreign direct investment, it has reflected foreigners lending you a lot of money, buying a lot of your bonds. Some part of your economy is, by definition, accumulating a decent amount of debt. In general, if the current account deficit is about 3%, you tend to be taking on data at a faster pace than your economy is growing. It's not a hard and fast rule, it's not always true, but the dynamics generally lean in that direction. And, there's often a sector of the economy that is taking on a lot debt. For the US now, it's obviously the federal government, which has a big fiscal deficit, and that's the counterpart, in a sense, to the US trade deficit. At various times in the past, it has been household borrowing. And, in the US, in the run up to the crisis, you have a lot of housing construction, a lot of that is financed by debt, you have a lot of households pulling equity out of their houses by borrowing, and all that was leading to higher levels of household consumption, a high level of investment in domestic real estate, and that housing exposure turned out to be the source of financial trouble, more so than the absolute size of the inflow.
Setser: But I think there tends to be a correlation. If you're running a really big current account deficit, someone tends to need to borrow a lot. And, in some cases, more in the emerging economies, excess fiscal deficits have given rise to trouble, typically when they're financed in a foreign currency, and then in the advanced economies, the housing booms that have led to large current account deficits have tended to be the proximate cause of bigger crises.
Beckworth: So, in general, the concern is, if you're running current account deficits above 3%, the concern is that you're running up debt, and at some point that that has to be paid back, and maybe sooner rather than later.
Setser: Well, as you guys have always argued, a lot of debt doesn't necessarily get paid back. It's just that you're running up the stock, and eventually you can't run up the stock more, and you have to start paying interest even if you're not paying the debt back. And the inability to run up your debt more, means is a shock and demand. And then, in some cases, you can't pay it back. A lot of the subprime borrowers had borrowed against the expected increase in the value of their home. They didn't actually have income to cover the ongoing interest expense, and in many of the subprime mortgages had features whereby the interest rate juiced up, jumped up, and so you got ... It would all work as long as housing prices only went up, but when housing prices went down, the income wasn't there to service the mortgage, and then those who lent money didn't get their money back, and then the financial system…
Beckworth: And the same thing for the US government, the concern is that, if they roll over treasury bills, they're going to face higher interest rates, and if all else fails, they can print money, but then you're going to create inflation if you're buying up the debt. So the concern is, you reach some limit, some point. And, the US is unique, it's different, because its reserve currency, it has some capabilities, but we're seeing this phenomenon, for example, in Turkey right now, to some extent, we'll talk about that a little later. You've written a lot on that.
Setser: I'm in Argentina right now, [crosstalk 00:26:02] is the best case, because that's ... Turkey's got a lot more of the banking crisis dynamics. Argentina, the fiscal deficit is driving the current account deficit. And unlike in the US, Argentina finances its fiscal deficit by selling bonds denominated in a foreign currency, which it can't print, and since they've been financing in dollars, it was exposed to the feds rate hike cycle, which is the classic story.
Beckworth: Let me ask this question then. So, what's happened in a nutshell is, there's these parts of the world that are saving more than they need, with that then they can spend domestically or invest domestically, so it has to find a home somewhere, and it finds it, usually, here in the US, which means we're living beyond our means. Now, the question is, would that have happened in the absence of these countries' policies doing what they did? For example, we mentioned China, there was foreign exchange intervention. So, the concern is China's manipulating its currency, even President Trump has been saying this. I think that may be a little bit dated now, but the concern was, China was trying to get some unfair advantage manipulating its currency, emerging markets maybe are trying to follow an export driven growth strategy, so they're making their exports as cheap as possible.
Beckworth: My question is, assume the government's did not explicitly follow those policies, or China did not manipulate its currency, would we still see a high savings rate because of where China is on the development ladder, and thus savings flowing out of China into the US?
Setser: No. I mean, that's heavily debated. My personal view is that, during the period when China really was intervening, when there was really a case that it was manipulating, i.e, holding its currency down, when it was adding at a spectacular rate to its reserves, broadly speaking, the period from 2003 to 2013. I think there are smaller concerns about manipulation now, but those concerns are in specific countries, not China, Taiwan, Thailand, making a surprisingly good case that Vietnam fits the criteria, but they're in the periphery of China. They're around China. I call it an arc of intervention, but it's everywhere, but China, so to speak, which is quite different from the world where China was intervening. My personal view is that, when China, at its peak, was adding, counting some of its hidden forms of intervention, 15% per year to its reserves and hidden reserves, that's a big number. And I think, if China had not been buying at that pace, the current account surplus would have been smaller, China's currency would have been significantly stronger. So, in my mind, there's very little doubt that there would have been adjustments to savings-
Beckworth: How much smaller would the current account surplus been? How did it get, and how small do you think it would have been had there not been this intervention?
Setser: So, I think a safe low end estimate ... China's current account surplus, at its peak, was about 10% of its GDP.
Beckworth: Which is crazy-
Setser: Crazy big. I mean, it's a little bigger as a share of its GDP going into the global crisis than Germany.
Beckworth: That's still striking; 10% of GDP, and that's just, wow.
Setser: It was big. I think it's been revised, so now it's a little bit below. There's a little bit of an air band measurement of the current account surplus, and how you count FDI, and go into all the boring details. So, around 10. Intervention at its peak was around 15. I would confidently say that without the intervention, the peak of China's surplus would have been below 5% of its GDP. That would imply a coefficient of about a third. Personally, I think the coefficient might be a Little bit higher, and so, China might have been in the two to 3% of GDP surplus range, which is where it is now. Part of that, though, is that China would, without as much support from the export side of its economy, put more emphasis on domestic policies to support demand. So, it's a joint equilibrium. Back when China exports were growing at the spectacular rates from 2002 to 2007, one of the biggest export booms in human history, China was actually limiting the amount that companies and others could borrow from the banks. They were pretty strict limits on the loan to deposit ratio, reserve requirements were jacked up, a lot of lending capacity was bottled up inside the banking system in order to keep inflation from going up.
Setser: So, one of the things that I would think would have happened is that, without the extra boost from exports, China would have allowed more domestic lending earlier, and perhaps had a looser fiscal policy as well, perhaps done more to develop a social safety net, and so, you would have had adjustments supported on both sides. Now, I think we've moved away from a world where the intervention is the main distortion, to a world where fiscal policy divergences are the biggest source of imbalances. The US has now, by a significant margin, the loosest fiscal policy of all the advanced economies. And most, not all, but most of the surplus countries, balance of payment surplus countries also have fiscal surpluses. So, Korea has a general government fiscal surplus, the Netherlands has a general government fiscal surplus, Germany, famously, has a general government fiscal surplus, and is under investing in public infrastructure. Sweden has a general government fiscal surplus. The Swiss, I think, have a small surplus. Japan's the exception. Japan has such a high level of corporate savings that even with a 4% of GDP, fiscal deficit is still running a pretty sizable current account surplus.
Setser: But by and large, right now, big differences in fiscal stance are leading to big differences in monetary stance, pushing the dollar up and driving current account, the structure of global financial flows right now.
Beckworth: Now, it's easier to think of policy responding to currency intervention, at least in my mind, it is. It's a easier argument to make. And even then, I think it gets tricky what you actually do in practice without triggering trade wars and spill back effects, but in the case of fiscal policy, like in Germany, I imagine it's got to be harder to address that. I could say from the US perspective, or anywhere else in the world, that, Germany's running this big current account surplus, and it's a result of tight fiscal policies, you've said. I can see two arguments pushing back against doing something about that; one, that's their choice, its fiscal policy, we can't force them to build more roads make more bridges. Secondly, man, isn't that a good thing; they're saving, they're not running big deficits? What do we do as a country from a policy perspective in response to these fiscal issues and these fiscal critiques, I guess?
Setser: You're right, it's hard, because fiscal choices are deeply domestic. I think, in some ways, the strongest argument against Germany's surplus comes from its euro area trade partners, because in the context of the euro area, there's a macroeconomic imbalances procedure, which in principle says that there's an obligation on the part of surplus countries if you have a surplus, I think, above 6% of GDP to try to bring it down. Of course, there's a similar obligation, in theory, on deficit countries, but, with both Germany and the Netherlands running really large surplus countries, and after the euro area crisis, the balance of payments deficits inside euro area, France has a small one no one else does. It's all in the surplus side. There's an argument that these tight fiscal policies are causing euro partners in a common currency, trouble. They're making it harder for countries that have depressed, still depressed, levels of demand, Italy, Spain to a lesser degree now, to rely on exports to Germany to power their economies, and create internal tensions.
Setser: There's also a conceptual argument that national policy choices have spillovers, and while it is your own sovereign right to determine your own fiscal stance, the US to run a big fiscal deficit, Germany to run a big surplus, it is also true that national policy choices have impacts on others. And, when those impacts are negative, I think it is fair for others to point that out. Globally, at least in my view, after the global financial crisis, most of the world has suffered from a shortfall in demand, and certainly there's been a shortfall in demand in the euro area. Euro area demand is now a little higher than it was in 2007, but that's over 10 years ago. You would expect it to be significantly higher. And so, that lack of demand in the euro area has held back Europe's recovery, which hurts the US, hurts our exports, has put pressure on the ECB to maintain negative interest rates, which pushes the Euro up, and has some spillovers.
Setser: So, I think there is a conceptual case that both parties in an imbalance would be better off if both adjusted their policies, particularly in a context where global demand is a little short. Putting all of the burden of adjustment on the deficit country, saying the entire problem is excessive fiscal deficits, in the European context, that was Greece, and saying surplus countries have no parallel responsibility, tends to lead to a contraction demand and slower overall growth, and conceptually, you can achieve better outcomes with symmetric adjustment. But I take the point that if you're running a fiscal surplus and paying down your debt, the rest of the world's points of leverage are pretty small.
Beckworth: And it's a tough argument to make to that country. What about monetary policy? Why couldn't the demand shortfall be addressed by the ECB in the case of the euro zone, running things a little bit hotter? I mean, couldn't that partially be the solution?
Setser: I mean, it is. And that's clearly-
Beckworth: But they haven't, obviously.
Setser: Well, I mean, they eventually got around to loosen their monetary policy.
Beckworth: Well, the inflation's still running really, really low. I mean-
Setser: Well, they do okay. It's not meeting their target. It's not meeting their target, in part, because fiscal policy hasn't been helping. So, when you're at the zero lower bound, I mean, it's actually a little bit below zero lower bound, monetary policy loses a little bit of its oomph. And so, conceptually, once interest rates get to zero or below zero, the easiest way to get the economy really going again, is if you combine zero interest rates with a positive fiscal impulse. And then the euro area, there's been a negative fiscal impulse. Various countries, other than Germany, that have deficits, have been under pressure to reduce those deficits, and Germany has not only maintained their surplus, has actually expanded its surplus over the past couple of years. So, without fiscal policy working together with monetary policy, even with relatively loose monetary policy, you don't necessarily get all the demands you need.
Setser: And then, monetary policy has a different set of spillovers. It tends to put down zero interest rates, and to put downward pressure on your currency, you tend to end up relying more on the rest of the world to pull yourself along, which is very clearly what has happened with the euro area. Euro area's current account surplus used to be before the global crisis, zero-ish, maybe a little bit of a deficit even when oil was high, a little bit of a surplus when oil was low. It is now closer to four than 3% of euro area GDP. So, for a big economy, that's a pretty large surplus, and then it has global consequences.
Beckworth: I guess this is where I would push back in arguing that the ECB could have done more. And clearly, I think it messed up in 2011 by raising rates twice in 2008. I mean, I think it definitely tightened and-
Setser: Look, there's zero agreement. I mean, I have argued that one ... One of my favorite blog post is an argument that the financial and economic policy establishment has been too soft on itself. And it says while we worked together, and we pulled ourselves out of the Great Recession, that, in practice, the ECB and the BOJ should have been doing QE along with the Fed. And then, if everyone had been doing QE together in '10, '11, '12, '13, we wouldn't be in the situation we are now, where the US is tightening, while everyone else is easing, or maintaining a very loose stance.
Beckworth: Policy divergence.
Setser: So, the policy divergence has reflected a failure on the part of, in my view, other countries to match US easing. And then I would also agree that, with hindsight, the ECB has done more easing-wise from '14 on, than the Fed did in 2010. We didn't do enough either. So, I think, globally, there was a significant air in direction, not enough easing on the monetary side in the immediate aftermath of the crisis, and in coordination, Europe and Japan didn't join the US when they should have.
Beckworth: Okay. Well, another long conversation related to that would be, what should the central banks be targeting? And, listening to the show, I would say nominal GDP level targeting would make it easier for them. But, let's move on, because we have Brad Setser here, and we can talk about other things besides the appropriate target for monetary policy. He has so much interesting work to share. Well, let's move to some of the recent emerging market tensions. We've touched on some of the issues in China, and I want to get to emerging markets in general. Maybe we'll come back to China, because you've written some interesting pieces on Turkey recently, you mentioned Argentina, tell us what's going on in Turkey, because Turkey seems to be in the headlines right now. And you mentioned banks, but is it banks, is it bad leadership there, is it corruption? What's the story behind Turkey's recent crisis?
Setser: Well, it's a banking sector that has borrowed extensively from the rest of the world, in foreign currency, at relatively short terms. And so, has built up a quite large stock of external debt that has to be rolled over. So that kind of the classic raw material of an emerging market crisis. That extra borrowing foreign currency came on top of what's called the domestic liability dollarization. So a lot of Turkey's domestic deposits are in dollars. And so, in addition to having a large stock of domestic dollar deposits, the Turkish banks went out and borrowed a lot of dollars and euros from the rest of the world. How do they use that borrowed money? Well, they have a lot of domestic foreign currency loans. So, part of the overall foreign currency funding was lent to domestic firms, and clearly, some of those domestic firms aren't really exporters, they don't really have foreign currency revenues, and there is a risk of loss. But if you look at it, Turkish domestic dollar deposits are roughly equal to domestic dollar loans. So there was a little bit more going on. And what I think is interesting about the Turkish case is that, the Turkish banks, through the swap market, were able to borrow dollars, say, issue a five year dollar bond, use those dollars as collateral in a swap agreement, and get lira from international investors, typically on a short tenure, so three month money, one month money.
Setser: And then they use that lira that they obtained, or hedged, they obtain to finance a very rapid growth in their lending to households. So it has some parallels with advanced economies that got into trouble because of heavy mortgage and consumer credit. This lending boom led to current account deficits, and that current account deficit has been big, 5% of GDP or more for a long time, and then it increased last year, going into the Fed's tightening cycle, going into a period when the direction of the dollar's movement changed. So, you have a period of a buildup of vulnerability, heavily in the banks and in the firms, but also some unique swap financed exposures. You have a current account deficit that increased at an inopportune time, and then you have growing questions about president Erdogan's leadership. Erdogan has always been a little unorthodox. He doesn't believe in particularly high real interest rates. He complains about the interest rate lobby, and he just generally has wanted the central bank to hold interest rates low relative to inflation. And, after getting another term of the presidency, he put his son in law in charge of the economy. There's a general sense that he is eroding Turkey's institutions.
Setser: And so, if you combine doubts about the policy framework, a Fed tightening cycle, big dollar exposures throughout the economy, and a lot of short term debt, external debt, you just have classic emerging market crisis raw material.
Beckworth: So, I have to mention, and you alluded to this, the Erdogan's fascination with what we'll call Neo-Fisherism. And as listeners of the show will know, I've had Steve Williamson on here before, a big proponent of Neo-Fisherism; the idea that the central banks actually need to raise interest rates to get higher inflation. So, Erdogan is promoting Neo-Fiserism in Turkey as a justification for his policies. As you mentioned, he's against the interest rate lobby. So, this has been a fascinating experiment with Neo-Fisherism that's not turning out to well. Conventional thinking does seem to be borne out here despite the faddish popularity with some for Neo-Fisherism. So, I had to put that in there. Although, Steve Williamson told me this is not a clean clear cut case of Neo-Fisherism, nonetheless. So, lot of dollar liabilities, some bad institutional developments, the Fed tightening.
Setser: The other factor, which is important in Turkey's cases, and it's important globally, is that Turkey imports oil, and oil prices have gone up. So, the interesting thing in both Turkey and Argentina is that their current account deficits spiked up a little bit even before the oil price jump in '17. And in Turkey's case, in part because there was an election, there was some quasi fiscal spending that seems to have pushed the current account deficit up, and that adds to, then, the doubts about the policy framework.
Beckworth: So, in addition to the dollar liabilities they have to pay off, they now have to somehow get more dollars to pay for the energy imports they need since they're in a real bind, real quandary. It was interesting, I saw in the Wall Street Journal today, they compared Russia to Turkey, and that is article ... One of the reason Russia is not having a similar experience, is because they have a central banker that Putin has given a lot of discretion to, and she has gone through and purged out really bad banks, and tried to get banks to be more solvent, do better lending, and maybe, in Turkey, maybe part of the decline institutional climate of banks having more free rein and getting these dollar liabilities. I'm not sure, but it's interesting divergence. And Russia has very low inflation, Turkey's very high inflation.
Beckworth: But I'm going to step back from the emerging market discussion and make a general observation and question for you. One of the developments that's a part of Turkey falling apart that's affected Argentina, is the feds tightening cycle, this policy divergence we talked about earlier. And this has always been an issue. So, in the early to mid 2000s, heck, going back to 1990s, remember Mexico's crisis, at least a part of it was tied to the Fed raising interest rates. The Fed has a large number of currencies that are either implicitly or explicitly tied to it. In fact, we had Ethan Ilzetzki on the show, but he has a paper with Reinhart and Rogoff, and they go and they try to estimate the number of currencies that are tied to the dollar, loosely, strongly, any form. And they estimate close to 70% of world GDP has its currency tied to the dollar. It's a very large number. In fact, it's about where it was during Bretton Woods if you look at their estimates. And even if that estimate seems high, the point is, we know there's still a lot of countries that, you follow this pretty closely, that loosely or tightly peg.
Beckworth: So the fact is, when the Fed tightens, when it loosens, it's exporting its policy to these countries. So, what is the world to do in a place where you have what I call a monetary superpower? What do you do as an emerging market? What do we recommend to the world as policymakers, when you have this huge player that affects the rest of the world dramatically? And, the other thing is, the Fed's mandate is not an international, it's domestic, so it can't be mindful, other than the feedback effects it creates domestically. Any thoughts on that?
Setser: No, I mean, I think this is going to be ... You've probably framed a discussion topic for the next three or four G20 meetings, because I'm sure a lot of emerging markets are going to be asking that question. They thought they had graduated from a world where, more or less, the Fed cycle was driving emerging markets' fortunes. And, there's been a significant amount of pressure so far this year, that is linked to the hiking cycle, but also, it's hiking plus a stronger dollar. Last year there was hiking and a weakening dollar for somewhat mysterious reasons, and there wasn't as much stress. What can you do? Well, the obvious answers are, limit your external debt, have large external reserves. So, one of Russia's sources of strength was a more orthodox policy framework, but if you go back and look at the combined foreign currency data of the Russian government, and the Russian state banks, and the big Russian State oil company, Rosneft to Gazprom, it was always a little less than the foreign currency reserves of the government of Russia. Russia can still experience shocks, but with that configuration of reserves and debt, it's hard to see how those shocks lead to systemic defaults.
Setser: There are other emerging economies that have a similar buffer. A consequence of that, though, is an emerging economies need a whole lot of reserves, and their capacity to draw on global financial markets to finance deficits, investment, rapid catch up to the levels of living standards in the advanced world, is probably somewhat crimped. The other thing which I think would make a difference, but it's hard, is to limit domestic dollar deposits. So, part of the linkage, globally, comes from monetary frameworks that are based on pegs, formal or informal, so you have to follow the Fed. But part of the linkage comes from domestic savers holding their own savings in dollars, which is a way emerging markets think, "Well, it's better to have dollars at home in our banks than dollars offshore that aren't helping us." But the consequence of liability dollarization is that the banks have dollars they need to match, they need to lend in dollars, and that's when the dollar goes up globally, and interest rates go up, and local currencies go down, there are significant domestic shocks.
Setser: So, I think, broadly speaking, prudent management of your balance sheet, limiting imbalances, no shock, but both Turkey and Argentina at current account deficits is about five. So, if you stick to a 3% of GDP rule of thumb, you're going to limit your vulnerabilities and if you are cautious about the banking system's dollar exposure, and it's particularly their short term dollar funding needs, you can limit vulnerabilities. But it, frankly, is still a little bit of a problem. And we've left aside the big one, which is, how can we exit from a world where China, more or less, tracks the dollar? It's definitely not full on dollar peg, it's basket peg, was managed against the dollar.
Beckworth: But it just doesn't differ too far away from the dollar, otherwise it might find problems with reserves leaving the country.
Setser: Well, if you freely float your ... If money wants to leave, that shows up in the currency, and your current account surplus goes up, it doesn't lead to drains on reserves, but since China doesn't freely float, when the currency is going down, people will tend to expect that it will continue to go down, more money leaves, there's pressure on reserves. I think in the long run, it would be helpful if China had its own autonomous monetary policy directed at Chinese domestic objectives kind of doesn't doesn't solve all of-
Beckworth: It’s still loosely follow the dollar.
Setser: Because if you have loosely follow the dollar for a really long time, and the transition could be quite a shock. And I think there are reasonable concerns that if China cut the anchor, that it would be disruptive. Back in 2009, 2010, 2011, China could have cut the anchor, and it would have allowed a tighter monetary policy, which would probably have been good for China, that was when the credit boom was really taking off, but it would have meant much stronger Chinese currency and a shock to China's trading sector. China didn't want that, and so it continued to maintain the dollar linkage, allowing some adjustments. Now, if China were to cut the linkage fully, the yuan might fall quite significantly, and that would really set the precedent off, really cause a lot of trade disruption globally. And since it's unlikely that China would really ever, given that many prices in China are controlled, and it wouldn't just be liberalizing the exchange rate, it would be liberalizing a lot of other prices, you could imagine that in the process, China might disrupt domestic expectations and trigger significant amounts of capital flight.
Setser: So you will get a slightly bad outcomes in China as well. Basically, it has at any given point in time been hard to completely untether the yuan for different reasons.
Beckworth: Now, was 2015 an example of where we saw the dollar strengthening causing stress in China?
Beckworth: Okay. So that's an example where, if they tried to sever, things could really run amok pretty quickly, if ...
Setser: I think that there, essentially, have been too broad currency regimes over the past 15 years. And the breaking point was 2014, when the Fed starts its tightening cycle, and the ECB and the BOJ are intensifying their easing, and the dollar appreciates ballpark by about 20%. That 20% rise in the dollar comes when oil prices are collapsing, and when China is inning for its own domestic reasons, a bit of a slump. So, it is unwelcome, but the oil currencies that were pegged to the dollar, followed the dollar up, and the yuan followed the dollar up. In '15, China concluded that it couldn't sustain that stronger yuan, and it wanted to adjust the yuan down without completely moving to a float. And that pulling off a control depreciation, which China did-
Beckworth: Just a little bit. I mean, it wasn't much, right?
Setser: It was about a 10%.
Beckworth: Oh, it's 10%. Okay.
Setser: So, the initial move was to three,...
Beckworth: I guess I was thinking about the initial one.
Setser: ...but then that that started a sequence of further depreciations. So, by mid '16, the cumulative move, both against the dollar, and against the basket, was about 10%; a little less.
Beckworth: But the initial depreciation, that was the one that triggered some of the financial stress. Is that right?
Setser: It was a shock, because up until the depreciation, the yuan had been totally pegged. And there was a sense that China was in the run up to get into SER and everything else, it would continue that peg. And so. the de-peg, initial depreciation, shift to management more against the basket, came as a shock. And it was seen as a sign that China wanted further weakening of the currency, and since it was seen as a sign about direction, that's just a one-off, it induced a lot of further outflows. And so, China had to burn through a lot of reserves to keep the depreciation managed, otherwise it would have floated down, and that would have been a bigger shock to the US. We would have seen a much more competitive China in trade markets.
Beckworth: So, in the closing minutes that we have here, any guidance for the Fed? What happens when you have a monetary superpower? What would you tell the Fed to do, if anything?
Setser: Look, I think the Fed is a little bit boxed in by the Trump administration's fiscal policy. We are currently doing a significant fiscal expansion that is pushing up demand at a point in time, where you can debate whether we're at full employment, or if you can ever define what full employment is, but the economy is clearly in a much stronger position than it was five years ago, or even two years ago, and it isn't clear that the economy really needs the extra jolt. So, I think the Fed reasonably thinks that, with the strong underline dynamics of US demand, the US needs a slightly tighter policy. I do think, and I think we saw this in 2015, that given that the Fed has a domestic mandate, there are limits on how much they can take the rest of the world into consideration, but the spill-backs, particularly if the spill-backs run through China, given China's size, can be so significant that the Fed does have to take them slightly into consideration. In '15, a lot of different things going on, but the Fed did pause its cycle.
Setser: I don't think the conditions now, warrant that. Remember, in '15, the falling oil prices proved to be less stimulative than expected, because the oil investment in the US fell, and that, more or less, offset any gain to consumer, and the dollar's big rise had a negative drag on trade, as you would expect. So growth in '15 was actually a little weak, and the Fed's pause was very much the right decision. We don't see that now. So that's the sense in which I think the Fed is tied. Conceptually, I do think that even the domestically oriented economy like the US, whose central bank has a domestic mandate, does need to take into consideration the ways in which US policy decisions reverberate and spill back. My strongest advice actually, though, is that, hey, I know it's hard, but the current configuration of fiscal and monetary policies amongst the advanced economies is wrong. Now, well, the US is doing fiscal expansion when it doesn't really need it, Europe is doing fiscal consolidation when it should be doing fiscal expansion, that is creating a quite large divergence in monetary policy that is moving the dollar to a pretty strong level, and that is not helping, at the minimum, emerging economies.
Setser: So, if you wanted a better global configuration of policy, it is not that hard to think of it, it's just very hard to see how you could get there. We are committed to a fiscal expansion, the Germans are committed to their fiscal policy, and that I really think that France, Italy, Spain should get their fiscal house in order, now that things are better. So, it just doesn't seem likely to happen, but that's where I know there's something obvious that could be done.
Beckworth: And the casualties will be the emerging markets.
Setser: Old school. Back where we started, back to 1997, but it won't be quite as bad as '97 in my view. There are countries that have weak fundamentals, weak balance sheets, too few reserves, but most emerging economies have more reserves, less external-
Beckworth: Because they've learned experience.
Setser: They've learned. So, as opposed to saying, almost all of the big emerging economies have some true underlying vulnerability, when a world where there are specific emerging economies that have very serious vulnerabilities, but you can look to some of the big guys, Russia, you've mentioned, Brazil, less clear cut, but a lot more reserves, India, [crosstalks 01:03:02] reserves. China is a strange case.
Beckworth: Three trillion, or…
Setser: Three-ish trillion, and a nice external loan portfolio, and some money in the China Investment Corporation.
Beckworth: But they're an outlier, is what you're saying.
Setser: Well, they're not short external assets, but in China, the concern is all the domestic debt. So, I think of China in some sense as not really fitting well within the rest of the emerging economies, just because it's so big. It's within shouting distance of the euro area, little smaller than the US. It's no longer a couple trillion dollar economy, it's a $12 trillion economy. And then its particulars are so unique to China that I find it very hard to discuss China, as in the same way that one discusses Brazil, for example. And I think China is also just an autonomous driver of global conditions in a way that others aren't.
Beckworth: That's fair. It's almost an exogenous force.
Setser: It is what it is. We don't talk of the US and Europe, and the euro area, as being part of one homogenous group. We talk of them as different entities, different cycles, different policies. And I really think, I need to think of it as China, euro area, US, and then a subset, and a group of emerging-
Beckworth: The new G3.
Setser: A new G3 that isn't coordinating.
Beckworth: Okay. Well, on that note, our time is up. Our guest today has been Brad Setser. Brad, thank you so much for coming on the show.
Setser: My pleasure. Thanks.