Thursday, November 29, 2007

Petrodollar Recycling in the Current Period

Petrodollar recycling, what oil exporters do with all that money, has been a problem from time to time. In the beginning the large oil exporters were not always sure what to do with their windfalls. But over time they figured it out. Also over time a lot more of us is going to be owned by someone else. Text in bold is my emphasis. From the WSJ:

With so many economic threats facing the U.S., consider for a moment an old worry: the fear that oil-producing nations wouldn't be able to "recycle" all the money they were collecting, to the detriment of the global economy.

Angst about "petrodollar recycling" made headlines in the 1970s. It's a worry that seems quaint today as the Abu Dhabi Investment Authority trades the proceeds of roughly 75 million barrels of oil -- about a week's worth of U.S. oil imports -- for a 4.9% stake in Citigroup.

Still, three decades ago there was genuine concern that the Organization of Petroleum Exporting Countries wouldn't know what to do with the windfall from the first oil shock. And there was fear that oil-importing countries, especially in the developing world, might try to compensate for their growing oil-induced trade deficits by reducing other imports.

The International Monetary Fund set up special "oil facilities" to lend to oil-thirsty developing nations that were running up huge trade gaps. U.S. Treasury Secretary William Simon lobbied oil producers to deposit petrodollars in U.S. banks and discouraged them from direct investment in U.S. companies -- amid talk Iran might buy a stake in ailing airline Pan Am, which is now defunct.

OPEC, it turned out, went on a buying binge. The money it did save, before oil prices fell, went into government securities or bank deposits. Commercial banks, in turn, increased lending to Latin America and other developing countries to bankers' later regret. With that prominent exception, though, "Recycling was carried out quite successfully in 1974-78," retired Federal Reserve economist Robert Solomon wrote in a monetary history of the period. "The problem turned out to be manageable after all."

Now oil prices are up, and money again is flowing from consumers in the U.S., Europe, Japan, China and India to producers who are -- as Edwin Truman of the Peterson Institute for International Economics puts it -- "taking wealth out of the ground and putting it above ground." Even if oil falls back to $70 a barrel, oil producers have nearly $2 billion to invest every day. So why so little worry about recycling petrodollars?

For starters, the global economy of the early 2000s has been far healthier than the stagflationary 1970s. The world has largely weaned itself off rigid foreign-exchange regimes, though not entirely, a problem for Middle Eastern countries whose dollar-linked currencies are sinking with the U.S. dollar when fundamentals suggest they should be rising. Global financial markets are far bigger than they were then.

The prospect of huge trade deficits doesn't seem as unsettling as it once did, perhaps because the U.S. has managed to maintain a large and (until recently) growing trade gap longer than doomsayers thought possible. And the biggest emerging markets are far more robust than they were 30 years ago. Indeed, China is running a huge trade surplus despite its hefty oil imports. And the IMF projects that, within a few years, funds managed by the investment arms of Asian governments and foreign-exchange reserves will be far bigger than OPEC's hoards.

It's clear oil producers are far more sophisticated investors than they were in the 1970s, though no one really knows where all the money is going. Simon Johnson, chief IMF economist, says only half the oil producers' windfall is accounted for. About 20% of their investing -- as opposed to spending on buildings or baubles -- is going into banks, much of that lent to emerging markets, the IMF says.

Another 30% shows up in U.S. Treasury reports as going into various U.S. securities. But those reports are incomplete -- partly because Saudi money managed in London and invested in U.S. stocks shows up as British, not Saudi. Much of the rest is believed to be going into stock markets around the world.

But there's only one big borrower in the global economy these days: the U.S. "The U.S. has been the ultimate destination -- even if has not been the direct destination -- for petrodollars recycled into the international financial markets," a trio of New York Fed economists wrote a few months ago.

Other oil importers, taken together, have curtailed consumer spending, boosted saving or reduced investment to avoid huge U.S.-style trade deficits that require financing from abroad.

Ron Paul, the Republican presidential candidate with some distinctly unconventional economic ideas, has this one right: "Right now we owe foreigners $2.7 trillion," he said in a recent debate. "No wonder they have money to come back in here and buy stuff up. And then we object … but that is a natural consequence of what happens when you live beyond your means."

So is all of this good or bad? Well, this money has helped keep U.S. interest rates one-half to three-quarters of a percentage point lower than they would otherwise be, a welcome counterweight to the economic harm done by higher oil prices. And, as the Citigroup deal illustrates, it's nice to have someone with capital to invest when American financial institutions suddenly need it, even if it is costly.

Yet every day, the U.S. economy sells a bit more of itself to oil producers and thrifty Asian economies because it doesn't save enough to finance its investment. In exchange, future profits from those assets will flow abroad instead of staying home.

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