Thursday, December 30, 2004

A Simple Reply

Why did Austrailia's economy act differently than Thailand's during the `97 crisis?

The main reason Austrailia's economy acted differently and survived the Asian crises is the fact that she is an advanced developed form of capitalism, compared to the tiger-nations that were an infant form of capitalism or outright mercantilism. The key word here is mercantilism. This is capitalism's oldest nemesis. Any dictionary gives a good enough meaning. All need be done is to substitute t-bills for gold and you have the answer - statecrafted manipulation of values and markets.

Nations who try to over-protect the local market with low exchange rate manipulation for export gain always lose when the rate or market fears turns against them, whereas Austrailia has always [in recent years] possessed a large consumption society to support it in downturns. Of course, the tigers had no well organized internal consumption market to turn to when foreign markets turned against them, so crash they did - too few exports and too little internal demand.

Markets must always be somewhere's near balanced to survive, long term. The balance must be internal and external markets, otherwise punishment is ahead. Even though the U.S., at present, is extremely unbalanced, it is able to survive such massive imbalances because it also possesses the world's largest consumption market, and one of the world's smallest export or import necessity markets. On the other hand, if you look at Japan, you will see an example of her mercantilist troubles played out since the early `90's. Japan was a large export and re-export market far too long, while over-protecting her local economy, thus overpricing her. When the exchange rate turned against her in `85 to `91, crisis developed - a major deflationary crisis. She's still not free and clear. At present, she has a large balance of payments surplus, yet her internal market is still in the dumper, due to the surplus coming from her MNC's overseas profits - after many abandoned the local market, due to exchange rates forcing them out, but originally due to her mercantilist state actions for years.

Now, the entire world is faced with big ol' mercantilist China and her copy-cat minions all over the world. We, the more well developed nations, face massive mercantilist pressures from all the world's low exchange rate and manipulated low rate nations. Just check for balance of payments surplusses by otherwise poor nations, and you will recognize these as mercantilist candidates - capitalism's massive problem. Even looking back at recent history, both Spain's and England's empires over-protected the local country with imperial preference trade laws, thus were mercantilist in nature. Only local entrepreneurial bussiness ventures and spirits, building local consumption markets beat this old demon, then, and now we possess the ability to pass the right trade and exchange laws, if the nations could be awakened from their great, Marxist era, trade sleep...

For an author to check out further writings, I would suggest a native of your own country, Stephen Kirchner at: Link Check out many of his links. As a matter of fact my last post at macromouse was from his site. Institutional Economics site is also listed in the links on macromouse at: Link Also check out Morgan Stanley's year end digest of 25 posts by their top economists from all over the world at: Link If you lose track of this address, as they change it, you can look it up in their site's archive of December 17, 2004. I just read it yesterday. It is quite thorough, and mentions some about mercantilism as does Kirchner's site.

Monday, December 20, 2004

Dollar Adjustment: How Far? Against What?

The Dollar: Where are we going?

C. Fred Bergsten and
John Williamson, editors

excerpt conclusions:
In summing up the conference, C. Fred Bergsten pointed to the stalemate that the system has reached. There is general agreement that the United States needs to curb quite substantially the size of its current account deficit. Most observers acknowledge that doing this will require a siz-able depreciation of the dollar. That implies a need for other currencies to appreciate against the dollar. Some currencies have already done so: the euro, the pound, the Swiss franc, the Canadian dollar, and the Australian and New Zealand dollars. (Indeed, some participants felt that several of these currencies might have overshot, although it is hard to believe that this remains true after the renewed strengthening of the dollar in early 2004.) Despite these corrections, the US dollar remains substantially over-valued.

One thing the conference did not reach agreement on is the magnitude of the current dollar overvaluation. Wren-Lewis went straight to estimates of equilibrium bilateral exchange rates, but if one weights and averages these, one would estimate on his measure that the dollar was overvalued by a little under 10 percent at the time of the conference. The figure of Bénassy-Quéré and her colleagues would seem to be about 4 percent, if one looks at their estimate of the dollar’s real effective overvaluation, although weighting their estimates of bilateral misalignments with the Federal Reserve’s weighting system would suggest a rather larger figure, again approaching 10 percent. O’Neill’s preferred estimate would also seem to be about 10 percent.

Mussa, conversely, asserted that a further dollar depreciation of about 20 percent or more would be needed to complete the adjustment process. Mann (2004) is even more alarmist, predicting that an immediate adjust-ment of close to 20 percent (enough to bring the Fed’s broad real index down to an index value of 85, as against its July 2004 value of 101.5) would do little more than stabilize the size of the US current account deficit. And to prevent the deficit from growing again in future years, the initial depre-ciation would need to be followed by a secular depreciation of about 10 percent a year (to offset the Houthakker-Magee asymmetry in the import elasticities and the growing deficit on the investment income account as the United States piles up foreign indebtedness, and to allow for an initial situation in which the value of imports vastly exceeds that of exports). What one can conclude is that the dollar is currently overvalued by at least 10 percent or so, and possibly by substantially more.

Yet the world has run out of volunteers for currency appreciation. Japan has already undertaken some appreciation, and its authorities fear that much more might derail the incipient recovery that looks as though it may finally be under way. China has a fixed nominal exchange rate with the dollar, and its officials parrot phrases about “keeping the yuan stable around a rational and balanced level” (ignoring the facts that stability in the bilateral rate against the dollar implies instability in what really mat-ters, the effective exchange rate, and that the present rate is by no stretch of the imagination reasonable and balanced). Other Asian countries resist substantial appreciation, even when their exchange rates are nominally floating, when this would also mean losing competitiveness against China. Canada and the eurozone are both relieved that the full appreciation of 2003 did not stick. Latin American countries seem determined not to re-peat their past mistake of acquiescing in overvalued exchange rates, and they may well be tempted to err in the opposite direction.

In this situation, there is an acute need to reach some measure of inter-national understanding about a consistent set of balance of payments ob-jectives and the resulting policy implications. Yet this is one responsibility that the IMF, the institution that is supposed to be in charge of supervising the adjustment process, seems singularly reluctant to fulfill. The G-7 and G-20 should tell the IMF that it is high time for it to accept its responsibility to negotiate an agreed-on and mutually consistent set of current account objectives. Unless the Institute’s conference was chronically mistaken, these objectives will have as a corollary an obligation to orchestrate a concerted Asian appreciation against the dollar and to encourage coun-tries with both deficits and surpluses to make the needed complementary adjustments in their policies regarding domestic demand.

No one doubts that adjustment will eventually happen. The sooner it starts, the less the chance that it will take a catastrophic form. If and when the worst happens, the world will surely not look back forgivingly at the present generation of officials who told themselves reassuring sto-ries about the omniscience of markets while allowing the disequilibria to explode.... The Dollar: - Link

Monday, December 13, 2004

The World On "Dollar Welfare" - "Welfare Arbitrage"

I can not understand why the world can not see what our massive deficits and debts actually add up to, and why there is not an outrageous outcry by more economists and citizens. The dollar is actually financing more welfare in foreign nations than it is at home. This massive expenditure is being borrowed from our children and grand-children. When will we awaken?

The Daniel Lian article below is only one of the many listed at the Morgan Stanley site about debating the dollar. I recommend everyone check out the December 10 archive for the full story. It should be scary, but I don't know when it will be.

What Are the Key Structural Issues Facing Asia?
by Daniel Lian

In my view, the global macro imbalance and a resulting significant transfer of wealth are the key structural challenges that Asia needs to address. In this respect, a review of history is helpful to provide context.

The chance of attaining economic sovereignty first presented itself to developing Asia in the 1950s after the end of the Second World War. This period also marked the beginning of the (rapid) end to western imperialism and colonization. The end of colonization meant that Asia had a wide-open platform to pursue economic development. After a brief flirtation with import substitution in the 1950s and 1960s by some Asian countries, most north-east and south-east Asian economies joined the band-wagon of export-orientation. China started to embrace some aspects of market economics in the late 1970s, and India started to experiment with economic liberalization and outward orientation a decade ago. So what is wrong with this seemingly ‘progressive’ path for Asia? The trouble is that it has been an extremely imbalanced development model.

Macro imbalance. The global economy has suffered massive global imbalance for the last several decades. This global imbalance has centered on saving – i.e., Asia’s excessive saving, compared with inadequate saving in the US and parts of the west. From another macro perspective, the imbalance is characterized by Asia’s massive export machine and appetite for Asian goods in the US and parts of the west. In a sense, Asia’s export machine has ensured that its current account surpluses have been finely balanced against the global imbalance in savings.

Unlike Andy, my chief concern is not so much about Asia losing export competitiveness and its sole growth engine, as the dollar structurally weakens, and more about the tremendous welfare costs that will hit the region if it retains its imbalanced model.

Welfare transfer. In my view, the world is experiencing the greatest welfare transfer ever seen across geographical regions and across generations. Such transfers are embodied in the macro imbalance characterized by Asia’s aggressive exports but passive savings in US Treasuries and other foreign (chiefly dollar) assets. Asia’s obsession with exports and savings has enabled present generations of the US and some parts of the developed world to sustain an unusually high rate of consumption, at the expense of current generations in Asia. This is because Asian exchange rates are artificially low and exports and wages are artificially cheap, and Asia has suppressed its present consumption to subsidize buyers of its exports. It also comes at the expense of future generations of the US economy and some parts of the developed world. At some point, present consumption in these countries will have to give way to savings to restore macro imbalances. Future generations will have to bear the economic burden of an aging population, as well as the devaluation of their currencies and the retirement of their public and private debt.

One would think future generations in Asia are the obvious winners as they inherit vast savings accumulated by their hardworking parents. However, their world is extremely uncertain and they face three major risks. First, wealth distribution has been heavily skewed and benefits relatively few. Poor governance means there is a good chance that their wealth will be squandered by the collective bad deeds of rent-seekers through systemic risk in Asia’s financial systems and asset markets. Second, it is hard to believe the unfortunate future generations of the US and other parts of the developed world will work doubly hard in their lifetimes to retire debt accumulated by their parents. It is more likely that they will simply raise inflation to reduce their debt burden at the expense of the future generations in Asia who inherit those excess savings. Third, with the likelihood of deteriorating demography (Asia will be growing older then), lack of intellectual property and economic ownership, and without the excessive consumption behavior of the west, Asia has insufficient economic means to accumulate wealth... Continued in archive of Dec. 10.

Thursday, December 09, 2004

The Lost Soul of Democrats

Well I've been searching for it for a long time - some forty odd years... Yes, we lost the election - but why? Now, if you allow me to indulge myself, I think I may be able to shed some light on some new reasons, and maybe point a way to recover our soul, and possibly even find a little new democratic integrity. As a child growing up in the fifties, I saw a very different world of Democrats than what I see today. And, sad to say, that difference today is not a good difference. My childhood memories contain visions of many very strong conservative Democrats, dispersed with a small number of liberal Democrats. Today, of course, that vision has been turned on its head. Now, is this the problem or not?

After researching, writing, participating in N.G.O.'s, and joining many academic/intellectual groups, I find a very disturbing trend. These groups are almost identical twins to the political culture at large. By this I mean the small ideas, in these groups as well as across the nation, are drowning out the large ideas, that usually support the small ideas. The populist left, populist liberals, and the populist centrist Democrat's small ideas are drowning out the necessary, conservative Democrat's large ideas. Now, the way I learned this story was that, logic dictates the large is more important than the small ideas, yet we just witnessed an election where our candidate had not one large idea or any semblance of a grand strategy, such as existed in the past - especially in such examples as Washington/Hamilton, Lincoln, and F.D.R. What is the reason for this? Have the Republicans set the agenda for the Democrats? Have the Democrats become blind to the fact that a conservative raft is necessary to lift the small ideas from the bottom of the deep well of arguement and confusion they have fallen into? Don't the Democrats see the sovereignty of the individual is being exploited, all over the world, by free markets and weak central governments, just as the neo-cons want it?

Historically and empirically, if we look back to better days we find our leaders realized democracy was, often times, too weak to stand on its own legs without the support of a strong central government. Hamilton/Washington, Lincoln, and F.D.R. all full well knew this and made the best out of a bad situation, and the country was greatly rewarded all three times. I mention these three incidents as they represent the greatest achievements in American political history. People may argue, but I think they'd be hard pressed to prop up other eras of greatness. Now this may go against the modern era's thinking, but the facts speak for themselves. Each era was marked by weak democracy being supported and saved by strong conservative government's new and revolutionary action. The easiest one for us to understand, of course, is F.D.R.'s New Deal, with its many liberal and conservative ideas being instituted. I simply argue that without his large and revolutionary conservative political and economic policies instituted, the smaller liberal policies would never have had a chance of survival. It always takes large political and economic reforms to support and fund the smaller, yet necessary as well, liberal ideas. I believe if we realize this, develop and re-enter the large conservative reforms and grand strategies necessary to fund our smaller liberal desires, we can recover a bit of the Democratic soul, and its lost integrity - and possibly win future elections - again.

If we can see great ideas, we can achieve greatness - again!

L.A. Gillespie

Wednesday, December 01, 2004

Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization

As far as I read this, Paul Samuelson has finally exposed enough truth to turn around the equilibrium theory, and free trade theories. This paper, that was originally published in September, is, in my opinion, the most important economic facts ever produced. If enough economists recognize the significance of Paul's refutation of his original work about equilibrium theory and facts, we have a chance of truly solving the world's problems.

If you check out Skidelsky's article I posted yesterday, and look at it in conjunction with this new post by Samuelson, I think you may come to the same conclusion I have. My conclusion is to look at Paul Davidson's and John M. Keynes' full works and realize how valid they truly are, now that the false equilibrium theory has been exposed by Samuelson. I'll have much more on this later...

Paul A. Samuelson
Most noneconomists are fearful when an emerging China or India, helped by their still low real wage rates, outsourcing and miracle export-led developments, cause layoffs from good American jobs. This is a hot issue now, and in the coming decade, it will not go away. Prominent and competent mainstream economists enter into the debate to educate and correct warm-hearted protestors who are against globalization. Here is a fair paraphrase of the argumentation that has been used recently by Alan Greenspan, Jagdish Bhagwati, Gregory Mankiw, Douglas Irwin and economists John or Jane Doe spread widely throughout academia.

Yes, good jobs may be lost here in the short run. But still total U.S. net national product must, by the economic laws of comparative advantage, be raised in the long run (and in China, too). The gains of the winners from free trade, properly measured, work out to exceed the losses of the losers. This is not by mysterious fuzzy magic, but rather comes from a sharing of the trade-induced rise in total global vectors of the goods and services that people in a democracy want. Never forget to tally the real gains of consumers alongside admitted possible losses of some producers in this working out of what Schumpeter called “creative capitalist destruction.”

Correct economic law recognizes that some American groups can be hurt by dynamic free trade. But correct economic law vindicates the word “creative” destruction by its proof [sic] that the gains of the American winners are big enough to more than compensate the losers.

The last paragraph can be only an innuendo. For it is dead wrong about necessary surplus of winnings over losings—as I proved in my “Little Nobel Lecture of 1972” (1972b) and elsewhere in references here cited (see also Johnson and Stafford, 1993; Gomory and Baumol, 2000). The present paper provides explication of the popular polemical untruth... Paul A. Samuelson - Continued


Tuesday, November 30, 2004

China Tells Currency Speculators to Get Lost:

China Tells Currency Speculators to Get Lost:
William Pesek Jr.

Here's an excellent currency article by Andy Xie.
A further one by Stephen Roach.
A most important article by Robert Skidelsky - The Bretton Woods System.

-- The world of currency markets is one of winks, nods and secret handshakes. In it, key policy makers rarely, if ever, say exactly what's on their mind. Chinese Premier Wen Jiabao has done just that and traders should pay close attention.

Wen said, as he often does, that China won't relax the currency's fixed exchange rate to the dollar under pressure from other countries. Yet he went a step further this week, issuing a warning of sorts to currency speculators.

``To be frank, it's not possible to launch changes to the yuan when speculation is so rife,'' he said here in Vientiane, Laos on Sunday. ``Rampant speculative activities on the yuan,'' he added, will make the introduction of any measures ``impossible.''

In other words, traders who test China's resolve may only delay a change in its currency peg. It means that the more investment banks churn out reports predicting yuan revaluations -- and the more speculators react to them -- the longer the process may play out.

Reality, Not Playbook
Wen isn't reading from the playbook of Mahathir Mohammad, the former Malaysian prime minister who infamously did battle with speculators during the 1997-1998 Asian crisis. Wen's comments were less of a threat than an admission of reality.

China understands how much the world wants it to let the yuan rise. Its officials also know it would be a powerful goodwill gesture that would reap political benefits in capitals all over the globe.

Yet China's economy isn't ready for a currency shift, and debt has much to do with it. The four biggest commercial banks in Asia's No. 2 economy are shackled with untold numbers of bad loans, putting its financial system in a highly fragile state.

Standard & Poor's thinks it would cost $656 billion to resolve bad loans at China's banks, though some analysts say the figure is probably much higher. Repairs are indeed under way, though not as fast as credit-rating companies would like.

Bad Loans
In January, China began using tens of billions of dollars of foreign exchange reserves to bail out lenders, and it's been pressuring bank executives to dispose of bad loans. More recently, it set new rules designed to make it easier for overseas investors to buy the more than $450 billion of bad loans held by China's four biggest commercial banks and their asset management companies.

Yet it's a work in progress. The last thing China wants is currency instability for the first time since 1995, when it pegged the yuan. While it's important that China reduce its currency advantage to restore a bit of equilibrium in global trade trends - - and placate the U.S. and Japan -- it's more important that it does it right.

China, Wen said, needs ``a stable macroeconomic environment, a normal market mechanism and a healthy financial system'' before it alters the peg. ``China needs to consider impact of the yuan on China and on the region.''

That's little comfort to Asian governments struggling to adjust to the dollar's 5.2 percent drop against the euro and 4.1 percent slide against the yen this year. As the dollar falls, China grows even more competitive in Asia. The trend threatens the export industries of the 10 members of the Association of Southeast Asian Nations, or Asean.

A Harbinger?
The good news is that this week's Asean meeting here in Vientiane may be a harbinger of Asian governments looking past China's dollar peg and letting currencies rise.

``We have to live with the fact that there will be a weaker U.S. dollar next year,'' Indonesian Trade Minister Mari Pangestu said in an interview. ``I don't think Indonesia should depreciate its currency to maintain its export competitiveness.''

Since Indonesia is by far Southeast Asia's biggest economy, such thinking shouldn't be dismissed. Japan also has shocked currency traders in recent weeks by doing nothing as the yen surged against the dollar. South Korea, which, like Japan, tends to manage its currency closely, also has been more tolerant of the rising won.

Sign of Confidence
It's an important step for this region -- a sign of confidence that may attract more foreign capital and lower bond yields. It will encourage economies and companies to reform instead of relying on cheap exchange rates as a crutch. And letting the dollar fall may be necessary to get record U.S. budget and current-account deficits under control.

A Chinese revaluation has been thought to be the key to getting Asians to let their currencies rise. Yet Japan's is by far Asia's biggest economy; only when Tokyo lets markets set the yen's value will China and others follow suit. If Japan does in fact allow the yen to appreciate, China may feel more comfortable taking a similar step.

Last week, analysts at Bank of America Corp. and Merrill Lynch & Co. made headlines predicting China may relax its 8.3 peg to the dollar by April to slow inflation and cool economic growth. That's probably wishful thinking, as Chinese officials are suggesting these days. Speculators might want to keep that in mind and trade accordingly.

Wednesday, November 24, 2004

The Dollar's Demise?

Here's an article to cheer you up or down. A few more economists had soon awaken to the world's currency realities. If not, we're in for a hell of a ride. If I were the president, I'd replace the entire administration with Keynesian economists, and straighten this mess out, pronto! It's only a currency law problem! It's the `73 change of law of the Bretton Woods System. That damn Nixon is still busting our butt.

Is the dollar’s role as the world’s reserve currency drawing to a close?

WHO believes in a strong dollar? Robert Rubin, Bill Clinton’s treasury secretary, most certainly did. John Snow, his successor but two, says he does but nobody believes him—if only because he wants other countries’ currencies, in particular the Chinese yuan, to go up. Mr Snow’s boss, President George Bush, in one of his mercifully rare forays into economics last week, also said he wants a muscular currency: “My nation is committed to a strong dollar.” Again, it would be fair to say that this was not taken as a ringing endorsement. “Bush’s strong-dollar policy is, in practical terms, to maintain a pool of fools to buy it all the way down,” a fund manager was quoted by Bloomberg news agency as saying. It does not help when the chairman of your central bank, Alan Greenspan, whose utterances on the economy are taken rather more seriously than Mr Bush’s, has said the day before that the dollar seems likely to fall: “Given the size of the current-account deficit, a diminished appetite for adding to dollar balances must occur at some point,” were his exact words. The foreign-exchange market immediately decided that it was sated, and the dollar fell to another record low against the euro.

Mr Greenspan’s words were of huge moment, and not just because he spoke clearly, unusual though this was, nor because the Federal Reserve rarely comments on foreign-exchange movements. No, Mr Greenspan’s words were significant because he was tacitly admitting what right-thinking economists the world over have long believed: that the emperor has no clothes.

Mr Greenspan’s previous line had been that America’s ever-expanding current-account deficit was not a problem when capital could flow so freely around the world; and that, in effect, it would continue to flow to America because the country is such a wonderful place in which to invest. Now he is saying that it won’t, or at least that investors will demand a cheaper dollar, or cheaper assets, or both, to carry on financing America’s deficit.

But Buttonwood suspects that the deeper significance of Mr Greenspan’s admission is that the game that has been played since the collapse of the Bretton Woods system in the early 1970s is drawing to a close. The dollar’s status as the world’s reserve currency—its preferred store of value, if you will—is gradually coming to an end. And, ironically, the fact that it has become so popular in recent years will only hasten its demise.

One man who undoubtedly believes in a strong dollar is Japan’s prime minister, Junichiro Koizumi. Unlike America, Japan has been putting its money where its leader’s mouth is. On behalf of the finance ministry, the Bank of Japan has bought more dollars than any other central bank has ever done. At last count, it had the equivalent of $820 billion in foreign-exchange reserves, most of it denominated in the American currency.

As goes Japan, so goes the rest of Asia. In an interview this week with the Financial Times, Li Ruogu, the deputy governor of China’s central bank, the People’s Bank of China, said that his country would not be rushed into revaluing the yuan, and that America should put its own shop in order. Mr Ruogu’s bank, too, has been a huge buyer of dollars in recent years. China and the rest of developing Asia now have $1.4 trillion of reserves, mostly dollars. This is more than the combined reserves of the rest of the world (excluding Japan). Thanks mostly to Asian intervention, foreign-exchange reserves at the world’s central banks have climbed from $2 trillion in 2000 to $3.5 trillion in 2004.

It used to be that countries amassed reserves as a war chest to protect against a run on their currencies of the sort suffered by East Asia in 1997, or Russia in 1998. But Asian countries have snaffled up far more than would be justified to prevent such crises. Their aim in accumulating these reserves is generally different now: to stop their currencies rising against the dollar and so keep their exports competitive. In effect, they are trying to peg their currencies; China’s peg is explicit. Huge foreign-exchange reserves are the result.

Some pundits have dubbed this arrangement the new Bretton Woods. The Bretton Woods arrangement (a post-second world war agreement that tied the dollar to gold and other currencies to the dollar) collapsed in 1971. The present arrangement seems similarly doomed to failure. The big question is whether the world will suffer similarly ill effects when it collapses.

Past saving?
The upward pressure on Asian countries’ currencies stems either from their saving too much and consuming too little, or from America saving too little and spending too much. American politicians, naturally, tend to concentrate on the first interpretation, because it stops them having to recommend unpleasant remedies, such as cutting deficits or encouraging Americans to save more. But Mr Greenspan’s most recent comments show that he recognises the problem is more home-grown. Personal saving in America, as a percentage of household income, slumped to just 0.2% in September, close to a record low. Indeed, the savings rate has been declining remorselessly since 1981, when it reached a high of 12.5%. This lack of saving shows up in the current-account deficit, which is a record near-6% of GDP and rising.

In effect, foreigners are saving on America’s behalf. In a recent study for the New York Fed, two economists, Matthew Higgins and Thomas Klitgaard, point out that the United States now absorbs more than the measured net saving of the rest of the world combined (suggesting someone’s got their figures wrong somewhere). The American economy cannot continue to expand at its current rate without those foreign savings. The question is whether foreigners will be happy to carry on financing this growth with the dollar and asset prices at their present level. The private sector is already voting with its wallet: it has been financing an ever smaller percentage of the deficit, and there has been a net outflow of direct investment. That leaves the public sector—ie, central banks—and those, in particular, of Asia.

At the heart of the central banks’ calculations is a trade-off: intervening to keep your currency down can be costly, but it is good for exports. Though the costs of intervention are hard to quantify, they are potentially big. Because the domestic money supply is expanded—those dollars must be paid for with something—it can cause inflation (though this can be neutralised through “sterilisation”, ie, bond sales). But the big potential cost is in amassing a huge stash of dollars with precious little exit strategy. Quite simply, Asian central banks now own too many of them to exit en masse, for their exit would cause the dollar to crash and American interest rates to soar, which would cause huge losses on their holdings of Treasuries.

Get out while you can
The biggest risk, of course, is that lenders would lose pots of money were the dollar to fall. As the printer of the world’s reserve currency, America can pass on foreign-exchange risk to the lenders because, unlike other indebted countries, it can borrow in its own currency. Messrs Higgins and Klitgaard reckon that for Singapore, the most extreme example, a 10% appreciation against the dollar and other reserve currencies would lead to a currency capital loss of 10% of GDP. Though loading up with even more dollars might of course stop the dollar from falling for a while, it would increase the risk of still larger losses were it eventually to do so. America already needs almost $2 billion a day from abroad to finance its spending habits, and the situation deteriorates by the week because America imports more than it exports, which worsens the current-account deficit.

The incentives to flee the Asian cartel (to give it its proper name) thus increase the bigger the game becomes. Why take the risk that another central bank will leave you carrying the can? Better to get out early. Because the game is thus so unstable it will come to an end, and probably a messy one. And what will then happen to the dollar? It is hard to imagine its hegemony remaining unchallenged when so many will have lost so much. And doubly so given that America has abused the dollar’s reserve-currency role so egregiously that its finances now look more like those of a banana republic than an economic superpower.

Tuesday, September 21, 2004

The Politics of Globalization

I've been trying to boil my ideas down to a grand strategy with a prime directive that is important and pertinent to the moment and dialogical to everyone. I've settled on "Truly Balanced Values" and "It's The Exchange Rates, Stupid." Now, I'm going to leave the exchange rates for the moment and discuss the dialogical problem...I've discovered by working in groups like this, that there is a giant linguistics mountain to hurdle, so we may communicate successfully with each other...

Should we continue playing bankruptcy capitalism? The system is broke financially and politically, yet, the solution is simple - the understanding and implementation is near impossible - our insecurities, fears and misinterpretations are blocking solutions and implementations. On the one hand, we have extreme under-funded wanton democracy and on the other, we have extreme over-funded speculative capitalism or extreme un-funded democracy verses extreme printed capitalism, yet we need a new Keynesian funded and balanced democracy.

The extreme capitalists see the problem as internal to the person, while they amass great concentrations of wealth. The extreme democrats see the problem as external to the person, while yearning for great dispersions of wealth. The three super-concentrations of wealth are tax havens - the oil rich nations and the 3rd world's super-rich. Is extreme democracy's grand strategy no more than desire? Do they see poverty is simply an illusion or reality of our stupidity? Has anyone glimpsed the great balancers of history? - the founding fathers -Washington, Marshall, Madison, and Hamilton or the great middle period balancer - Lincoln, or more recent balancers - Roosevelt and Truman's Keynesian truly funded and balanced ideas and policies? After studying these great men who knew what to do with the closed wallet of concentrated wealth verses the open wallet of dispersed wealth, I easily came to the conclusion, we needed a new global financial democracy, re-founded on the best ideas of these great men's minds.

The entire world's core values are the problem and solution. We need the best balanced autonomous solution - an authentic grand strategy. The prime directive should be based on growth and balance - a truly new and full balance, from the bottom of our values systems to the top and most hierarchical law structures. The middle path is the road of true balance, yet, we must recognize the limits of capitalism and her sovereignty. We must rebalance social democracy verses market concentrations. Growth of the public good supports social democracy, historically, yet, we must ask - "has globalization gone too far?" While answering, we shouldn't seek perfect government, we should seek perfect competitions, because the imbalances inherent in extreme capitalism are defeating its purpose - hands down!

The intuitive universal truths of common sense show us the modern world is adrift on a sea of unknowing, yet, must we endure a visionless world? Using vision logic, can we glimpse truth as a balance of money and values? or has reason gone mad, trapping us in the horrendous global imbalances? I think not. If we use a major global strategy of thinking locally and acting globally, through policy reform proposals geared to spiritualism's balance of ideas - the world perfect ideas or a perfect competition balance of as many truths as possible, we can surmount a grand strategy to rebalance most of America's values through a true new balance - the center of a new democracy.

I'll say it again, we need a grand strategy - a balanced strategy, and the American mind is wide open to change. At present, the system is so imbalanced, it's robbing itself, yet, in the absolute, there are no problems - it's all a matter of perception. There's answers and solutions to all problems - we just can't talk truth - yet! As ol' man Bechtel used to say, "Problems are just opportunities in work-clothes." Yes, it is true, we have a long way to go, but if we concentrate on the real political problems of globalization's two major causes of technological and state action, and globalization's two major aspects of free trade and free capital, we may start to understand the three stages of mythic, real and integral capitalism. We may further be able to work toward a supra-rational omega structure - a global democracy of money invested in perfect competition, instead of our blindness to possibilities. We must curtail the demonizing of truth and wisdom and seek real and balanced solutions!

Here's a compliment to my post - Thaksinomics - A New New Deal
A globalization article by George Monbiot - "The Age of Consent" - "Without global democracy, national democracy is impossible."
A new Stephen Roach post on Globalization - China/Europe/America
A new post by Martin Hutchinson - Economics & Globalization of Russia
A new post - Speculation in Derivatives, etc.
Bluster and Debt Fill the Sails of the USS Macroeconomy
Andy Xie on China and America, Debt Troubles

Tuesday, September 14, 2004

The Risks Ahead For The World Economy

The Economist

Fred Bergsten explains why policymakers need to act now in order to avert the danger of serious damage to the world economy

FIVE major risks threaten the world economy. Three centre on the United States: renewed sharp increases in the current-account deficit leading to a crash of the dollar; a budget profile that is out of control; and an outbreak of trade protectionism. A fourth relates to China, which faces a possible hard landing from its recent overheating. The fifth is that oil prices could rise to $60-70 per barrel even without a major political or terrorist disruption, and much higher with one.

Most of these risks reinforce each other. A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates. A sharp dollar decline would increase the likelihood of further oil price rises. Larger budget deficits will produce larger American trade deficits, and thus more protectionism and dollar vulnerability. Realisation of any one of the five risks could substantially reduce world growth. If two or three, let alone all five, were to occur in combination then they would radically reverse the global outlook.

There is still time to head off each of these risks. Decisions made in America immediately after this year's elections will be pivotal. China, the new growth locomotive, is key to resolving the global trade imbalances and must play a central role in future. Action by a number of other countries will be essential to maintain global growth and to avoid deeper oil shocks and new trade restrictions.

The most alarming new prospect is another sharp deterioration in America's current-account deficit. It has already reached an annual rate of $600 billion, well above 5% of the economy. New projections by my colleague Catherine Mann (see chart 1) suggest it will now be rising again by a full percentage point of GDP per year, as actually occurred in 1997-2000. On such a trajectory, the deficit would exceed $1 trillion per year by 2010.

There are three reasons for this dismal prospect. First, American merchandise imports are now almost twice as large as exports; hence exports would have to grow twice as fast as imports merely to halt the deterioration. (In the past, such a relationship occurred only after the massive fall experienced by the dollar in 1985-87.) Second, economic growth is likely to remain faster in America than in its major markets and higher incomes there increase demand for imports much faster than income growth elsewhere increases demand for American exports. Third, America's large debtor position (it currently is in the red by more than $2.5 trillion) means that its net investment income payments to foreigners will escalate steadily, especially as interest rates rise.

Of course, it is virtually inconceivable that the markets will permit such deficits to eventuate. The only issue is how they are to be averted. An immediate resumption of the gradual decline of the dollar, as in the period 2002-03, cumulating in a fall of at least another 20%, is needed to reduce the deficits to sustainable levels.
If delayed much longer, the dollar's inevitable fall is likely to be much larger and much faster. Moreover, much of the slack in America's product and labour markets will probably have disappeared in a year or so. Sharp dollar depreciation at that stage would push up inflation and macroeconomic models suggest that American interest rates could even hit double digits.

The situation would be still worse if future increases in energy prices and the budget deficit compound such developments, as they surely could. The negative impact would also be much greater in other countries because of their need to generate larger and faster domestic demand increases in order to offset declining trade surpluses.

Fears of a hard landing for the dollar and the world economy are of course not new. The situation is much more ominous today, however, because of the record current-account deficits and international debt, and the high probability of further rapid increases in both. The potential escalation of oil prices suggests a parallel with the dollar declines of the 1970s, which were associated with stagflation, rather than the 1980s when a sharp fall in energy costs and inflation cushioned dollar depreciation (but still produced higher interest rates and Black Monday for the stockmarket). Paul Volcker, former chairman of the Federal Reserve, predicts with 75% probability a sharp fall in the dollar within five years.

The prospects for the budget deficit and trade protectionism further darken the picture. Official projections score the fiscal imbalance at a cumulative $5 trillion over the next decade, but exclude probable increases in overseas military and homeland-security expenditures, extension of the recent tax cuts and new entitlement increases proposed by both presidential candidates. This deficit could also approach $1 trillion per year (see chart 2), yet there is no serious discussion of how to restore fiscal responsibility, let alone an agreed strategy for reining in runaway entitlement programmes (especially Medicare).

Different deficits
The budget and current-account deficits are not “twin”. The budget in fact moved from large deficit in the early 1990s into surplus in 1999-2001, while the external imbalance soared anew. But increased fiscal shortfalls, especially with the economy nearing full employment, will intensify the need for foreign capital. The external deficit would almost certainly rise further as a result.

Robert Rubin, former secretary of the Treasury, also stresses the psychological importance for financial markets of expectations concerning the American budget position. If that deficit is viewed as likely to rise substantially, without any correction in sight, confidence in America's financial instruments and currency could crack. The dollar could fall sharply as it did in 1971-73, 1978-79, 1985-87 and 1994-95. Market interest rates would rise substantially and the Federal Reserve would probably have to push them still higher to limit the acceleration of inflation.

These risks could be intensified by the change in leadership that will presumably take place at the Federal Reserve Board in less than two years, inevitably creating new uncertainties after 25 years of superb stewardship by Mr Volcker and Alan Greenspan. A very hard landing is not inevitable but neither is it unlikely.

The third component of the “America problem” is trade protectionism. The leading indicator of American protection is not the unemployment rate, but rather overvaluation of the dollar and its attendant external deficits, which sharply alter the politics of trade policy. It was domestic political, rather than international financial, pressure that forced previous administrations (Nixon in 1971, Reagan in 1985) aggressively to seek dollar depreciation. The hubbub over outsourcing and the launching of a spate of trade actions against China are the latest cases in point. The current-account, and related budget, imbalances may not be sustainable for much longer, even if foreign investors and central banks prove willing to continue funding them for a while.
The fourth big risk centres on China, which has accounted for over 20% of world trade growth for the past three years. Fuelled by runaway credit expansion and unsustainable levels of investment, which recently approached half of GDP, Chinese growth must slow. The leadership that took office in early 2003 ignored the problem for a year. It has finally adopted a peculiar mix of market-related policies, such as higher reserve requirements for the banks, and traditional command-and-control directives, such as cessation of lending to certain sectors. The ultimate success of these measures is highly uncertain.

Under the best of circumstances, China's expansion will decelerate gradually but substantially from its recent 9-10% pace. When the country cooled its last excessive boom after 1992, growth declined for seven straight years. A truly hard landing could be much more abrupt and severe. Either outcome will, to a degree, counter the inflationary and interest-rate consequences of the other global risks. But a slowdown, and especially a hard landing, in China would sharply reinforce their dampening effects on world growth.

The fifth threat is energy prices. In the short run, the rapid growth of world demand, low private inventories, shortages of refining and other infrastructure (particularly in America), continued American purchases for its strategic reserve and fears of supply disruptions have outstripped the possibilities for increased production. Hence prices have recently hit record highs in nominal terms. The impact is extremely significant since every sustained rise of $10 per barrel in the world price takes $250 billion-300 billion (equivalent to about half a percentage point) off annual global growth for several years. Mr Greenspan frequently notes that all three major post-war recessions have been triggered by sharp increases in the price of oil.

My colleague Philip Verleger concludes that this lethal combination could push the price to $60-70 per barrel over the next year or two, perhaps exceeding the record high of 1980 in real terms. Gasoline prices per gallon in America would rise from under $2 now to $2.60 in 2006. Prices would climb even more if political or terrorist events were further to unsettle production in the Middle East, the former Soviet Union or elsewhere.

Curtail the cartel
The more fundamental energy problem is the oligopolistic nature of the market. The OPEC cartel in general, and dominant supplier Saudi Arabia in particular, restrict supply in the short run and output capacity in the long run to maintain prices far above what a competitive market would generate. They do not always succeed and indeed have suffered several sharp price falls over the past three decades. They are often unable to counter excessive price escalation when they want to, as at present.

Primarily due to the cartel, however, the world price has averaged about twice the cost of production over the past three decades. The recent price above $40 per barrel compares with production charges of $15-20 per barrel in the highest-cost locales and much lower marginal costs in many OPEC countries. This underlying problem also looks likely to get worse, as the Saudis have talked openly about increasing their target range from the traditional $22-28 per barrel to $30-40.

There is a high probability that one or more of these risks to global prosperity and stability will eventuate. The consequences for the world economy of several of them reinforcing each other are potentially disastrous. All five risks can be avoided, however, or their adverse effects at least substantially dampened, by timely policy actions. The most important single step is for the president of the United States to present and aggressively pursue a credible programme to cut the federal budget deficit at least in half over the coming four years and to sustain the improvement thereafter. This will require a combination of spending cuts, revenue increases and procedural changes (including the restoration of “PAYGO” rules in Congress), as well as rapid economic growth.

Such a programme would maximise the prospects for maintaining solid growth in America and the world by avoiding the crowding out of private-sector investment and by reducing the likelihood of higher interest rates. It would represent the best insurance against a hard landing via the dollar, by buttressing global confidence in the American economy. It should be feasible, having been more than accomplished during the 1990s. Its absence would virtually assure realisation of at least some of the inter-related global risks within the next presidential term.

An energy stability pact
America and its allies must also move decisively on energy. Sales from their strategic reserves, which total about 1.3 billion barrels (including 700m in the United States), would reverse the recent price increases for at least a while and demonstrate a willingness to counter OPEC. For the longer run, America must expand production (including in Alaska) and increase conservation (especially for motor vehicles). Democrats and Republicans must together take the political heat of establishing a gasoline, carbon or energy tax that will limit consumption, help protect the environment and reduce the need for future military interventions abroad.

All three major post-war recessions have been triggered by sharp increases in the price of oil
The most effective “jobs programme” for any American administration and the world as a whole, however, would be an initiative to align the global oil price with levels that would result from market forces. America should therefore seek agreement among importing countries (including China, India and other large developing importers as well as industrialised members of the International Energy Agency) to offer the producers an agreement to stabilise prices within a fairly wide range centred at about $20 per barrel.

Consumers would buy for their reserves to avoid declines below the floor of the range and sell from those reserves to preserve its ceiling. A sustained cut of $20 per barrel in the world price could add a full percentage point to annual global growth for at least several years. The resultant stabilisation of price swings would avoid the periodic spikes (in both directions) that tend to trigger huge economic disruption. Producers would benefit from these global economic gains, from their new protection against sharp price falls and from trade concessions that could be included in the compact to help them diversify their economies.

China must also play a central role in protecting the global outlook. Fortunately, it can resolve its internal overheating problem and contribute substantially to the needed global rebalancing through the single step of revaluing the renminbi by 20-25%. Such a currency adjustment would simultaneously address all of China's domestic troubles: dampening demand (for its exports) by enough to cut economic growth to the official target of 7%; countering inflation (now approaching double digits for inter-company transactions) directly by cutting prices of imports; and checking the inflow of speculative capital that fuels monetary expansion.

A sizeable renminbi revaluation is also crucial for global adjustment because much of the further fall of the dollar needs to take place against the East Asian currencies. These have risen little if at all, although their countries run the bulk of the world's trade surpluses. China has greatly intensified the problem by maintaining its dollar peg and riding the dollar down against most other currencies, further improving its competitiveness. Other Asian countries, from Japan through India, have thus intervened massively to keep their currencies from appreciating against the dollar (and, with it, against the renminbi). This has severely limited correction of the American deficit and thrown the corresponding surplus reduction on to Europe and a few others with freely flexible exchange rates. China should reject the US/G-7/IMF advice to float its currency, which is far too risky in light of its weak banking system and could even produce a weaker renminbi, and opt instead for a substantial one-shot revaluation. It should in fact take the lead in working out an “Asian Plaza Agreement” to ensure that all the major Asian countries make their necessary contributions to global adjustment.

Countries that undergo currency appreciation, and thus face reductions in their trade surpluses, will need to expand domestic demand to sustain global growth. China need not do so now because it must cool its overheated economy. But the other surplus countries, including Japan and the euro area, will have to implement structural reforms and new macroeconomic policies to pick up the slack. America and the surplus countries should also work together to forge a successful Doha round, renewing the momentum of trade liberalisation and reducing the risks of protectionist backsliding.

Risk in our times
The global economy faces a number of major risks that, especially in combination, could throw it back into rapid inflation, high interest rates, much slower growth or even recession, rising unemployment, currency conflict and protectionism. Even worse contingencies could of course be envisaged: a terrorist attack with far larger economic repercussions than September 11th or a sharp slowdown in American productivity growth, as occurred after the oil shocks of the 1970s, that would further undermine the outlook for both economic expansion and the dollar.

Fortunately, policy initiatives are available that would avoid or minimise the costs of the most evident risks. America will be central to achieving such an outcome and the president and Congress will have to decide in early 2005 whether to address these problems aggressively or simply avert their eyes and hope for the best, taking major risks with their own political futures as well as with the world economy. China will have to play a new and decisive leadership role. The major oil producers and the other large economies must do their part. The outlook for the global economy for at least the next few years hangs in the balance. ...Link

Fred Bergsten is director of the Institute for International Economics in Washington, DC. His book, “The United States and the World Economy: Foreign Economic Policy for the Next Administration” is forthcoming.

Thursday, September 09, 2004

China 's Great Depression

With a grain of salt.

Dr. Krassimir Petrov is a disciple of the Austrian School of Economics and spent this summer at the Mises Institute of Austrian Economics at Auburn , Alabama.

Having recently completed Rothbard's “America's Great Depression”, I couldn't help draw the parallels between America's roaring 20's and China's roaring economy today, and I couldn't help conclude that China will inevitably fall in a depression just like America did during the 1930s. The objective of this article is to present an Austrian argument as to why this must happen; to substantiate my arguments, I will be quoting Rothbard's Fifth Edition where relevant.

Before proceeding any further, I would urge all readers who haven't read Rothbard's “ America 's Great Depression”, to pick up a copy and read it. First, it is a real pleasant read, and Rothbard's witty style of writing makes reading it fun. Second, the first part of the book develops the Austrian Business Cycle Theory, which is indispensable for understanding credit booms and their inevitable busts. Finally, the second part of the book elaborates the development and the causes of the Inflationary Boom of the 1920s and provides a basis for comparison with the economic policies of modern-day China .

In order to establish our parallel, we need some historical perspective of the relationship between a world superpower and a rising economic giant. In the 1920s, Great Britain was the superpower of the world, and the United States was the rising giant. As such, Great Britain ran its economic policies independently, and the U.S. adapted its own policies in a somewhat subordinated manner. Today, The United States is the hegemonic superpower of the world, and China is the rising economic giant. Not surprisingly, the U.S. runs its policy independently, while China adjusts its own accordingly.

Continuing our parallel analysis, during the 1920s the British Empire was already in decline, was militarily overextended, and in order to pay for its imperial adventures, resorted to debasing its own currency and running continuous foreign trade and budget deficits. In other words, Britain was savings-short, a net-debtor nation, and the rest of the world was financing her. Meanwhile, America was running trade surpluses and was a net creditor nation. Importantly from a historical point of view, the British Empire collapsed when the rest of the world pulled the plug on their credit and began capital repatriation. Today, the American Empire is in decline, is militarily overextended, and is financing her overextended empire with the “tried-and-true” methods of currency debasement and never-ending foreign trade and budget deficits. In other words, America is savings-starved, a net-debtor nation, and the rest of the world is financing her. At the same time, today China runs trade surpluses and is a net-creditor nation. When the rest of the world finally pulls the plug on American credit, will the American Empire also collapse?

The cause of the Depression, as Rothbard explains, was a credit expansion that fuelled the boom. According to Rothbard, “[o]ver the entire period of the boom, we find that the money supply increased by $28.0 billion, a 61.8 percent increase over the eight year period [of 1921-1929]. This was an average annual increase of 7.7 percent, a very sizable degree of inflation (p.93)…The entire monetary expansion took place in money substitutes, which are products of credit creation… The prime factor in generating the inflation of the 1920s was the increase in total bank reserves” (p.102). In other words, during the 1920s, the United States experienced an inflationary credit boom. This was most evident in the booming stock and the booming real estate markets. Furthermore, there was a “spectacular boom in foreign bonds… It was a direct reflection of American credit expansion, and particularly of the low interest rates generated by that expansion” (p.130). To stem the boom, the Fed attempted in vain to use moral suasion on the markets and restrain credit expansion only for “legitimate business. Importantly, consumer “prices generally remained stable and even fell slightly over the period” (p. 86). No doubt the stable consumer prices contributed to the overall sense of economic stability, and the majority of professional economists then did not realize that the economy was not fundamentally sound. To them the bust came as a surprise.

Today, in a similar fashion, the seeds of Depression are sown in China . Economists hail the growth of China , many not realizing that China is undergoing an inflationary credit boom that dwarfs that American one during the roaring ‘20s. According to official government statistics, 2002 Chinese GDP growth was 8%, and 2003 growth was 8.5%, and some analysts believe these numbers to be conservative. According to the People's Bank of China own web site (, “Money & Quasi Money Supply” for 2001/01 was 11.89 trillion, for 2002/01 was 15.96 trillion, for 2003/01 was 19.05 trillion, and for 2004/01 was 22.51 trillion yuan. In other words, money supply for 2001, 2002, and 2003 grew respectively 34.2%, 19.3%, and 18.1%. Thus, during the last three years, money supply in China grew approximately three times faster than money supply in the U.S. during the 1920s.

No wonder the Chinese stock market has been booming and the Chinese real estate market is on fire. Just like the U.S. in the 20s, China finances today foreign countries, mostly the U.S. , by buying U.S. government bonds with their trade surplus dollars. Just like the Fed's failed attempts of moral suasion during the 20s, the Chinese government today similarly attempts in vain to curtail growth of credit by providing it only to those industries that need it, that is, only to industries that the government endorses for usually political reasons. Also, for most of the current boom, Chinese consumer prices have been mostly tame and even falling, while prices for raw commodities have been skyrocketing, which perfectly fits the Austrian view that prices of higher-order goods, such as raw materials, should rise relative to prices of lower-order goods, such as consumer goods. This indeed confirms that credit expansion has already been in progress for a considerable time, and that inflation now is in an advanced stage, although it has not yet reached a runaway mode. Thus, economic conditions in China today are strikingly similar to those in America during the 1920s, and the multi-year credit expansion implies that a bust is inevitable.

There are also important parallels regarding currency and export policy. During the 1920s, the British Pound was overvalued and was used by smaller countries as a reserve currency. While Britain ran its inflationary policies during the 1920's, it was losing gold to other countries, mainly the United States . Therefore, “if the United States government were to inflate American money, Great Britain would no longer lose gold to the United States” (p. 143). Exacerbating the problem further, the Americans artificially stimulated foreign lending, which further strengthened American farm exports, aggravated the net-export problem, and accelerated the gold flow imbalances. “It [foreign lending] also established American trade, not on a solid foundation of reciprocal and productive exchange, but on a feverish promotion of loans later revealed to be unsound” (p. 139). “[President] Hoover was so enthusiastic about subsidizing foreign loans that he commented later that even bad loans helped American exports and thus provided a cheap form of relief and employment—a cheap form that later brought expensive defaults and financial distress” (p.141) Thus, the preceding discussion makes it clear, that the fundamental reasons behind the American inflationary policy were (1) to check Great Britain's drains of gold to the United States, (2) to stimulate foreign lending, and (3) to stimulate agricultural exports.

Similarly, today the dollar is overvalued and used as the reserve currency of the world. The U.S. runs its inflationary policy and is losing dollars to the rest of the world, mainly China (and Japan ). Today, the currency and export policy of China is anchored around its peg to the dollar. The main reason for this is that by artificially undervaluing its own currency, and therefore overvaluing the dollar, China artificially stimulates its manufacturing exports. The second reason is that by buying the excess U.S. dollars and reinvesting them in U.S. government bonds, it acts as a foreign lender to the United States . The third reason is that this foreign lending stimulates American demand for Chinese manufacturing exports and allows the Chinese government to relieve its current unemployment problems. In other words, the motives behind the Chinese currency and export policy today are identical to the American ones during the 1920s: (1) to support the overvalued U.S. dollar, (2) to stimulate foreign lending, and (3) to stimulate its manufacturing exports. Just like America in the 1920s, China establishes its trade today not on the solid foundation of reciprocal and productive exchange, but on the basis of foreign loans. No doubt, most of these loans will turn out to be very expensive because they will be repaid with greatly depreciated dollars, which in turn will exacerbate down the road the growing financial distress of the banking sector in China .

Therefore, it is clear that China travels today the road to Depression. How severe this depression will be, will critically depend on two developments. First, how much longer the Chinese government will pursue the inflationary policy, and second how doggedly it will fight the bust. The longer it expands and the more its fights the bust, the more likely it is that the Chinese Depression will turn into a Great Depression. Also, it is important to realize that just like America 's Great Depression in the 1930s triggered a worldwide Depression, similarly a Chinese Depression will trigger a bust in the U.S. , and therefore a recession in the rest of the world.
Unless there is an unforeseen banking, currency, or a derivative crisis spreading throughout the world, it is my belief that the Chinese bust will occur sometime in 2008-2009, since the Chinese government will surely pursue expansionary policies until the 2008 Summer Olympic Games in China. By then, inflation will be most likely out of control, probably already in runaway mode, and the government will have no choice but to slam the brakes and induce contraction. In 1929 the expansion stopped in July, the stock market broke in October, and the economy collapsed in early 1930. Thus, providing for a latency period of approximately half a year between credit contraction and economic collapse, based on my Olympic Games timing, I would pinpoint the bust for 2009. Admittedly, this is a pure speculation on my part; naturally, the bust could occur sooner or later.

While I base my timing of bust on the 2008 Olympic Games, Marc Faber, however, believes the bust will occur sooner. According to him, the U.S. is due for a meaningful recession relatively soon, which in turn will exacerbate already existing manufacturing overcapacities in China . This, coupled with growing credit problems, makes him believe that China will tip into recession sooner than the Olympic Games. In other words, Dr. Faber believes that a U.S. recession will trigger the Depression in China . Indeed, that very well may be the trigger, but if so, it still remains to be seen whether the Chinese government will let the bust run its course or choose the route of a “crack-up” boom, come hell or high water.

We should also consider another possible trigger for a bust, namely trade surpluses turning into trade deficits due to the accelerated rise of prices for resources, such as commodities, which China must import. Faced with trade deficits, China may decide to dishoard surpluses by selling U.S. government bonds, or it may decide to abandon its peg to the dollar. In either case, this will exacerbate the problems of the ailing U.S. economy, which in turn will boomerang back to China .

Finally, the bust may be triggered by a worldwide crisis in crude oil supplies. Peak oil supply is around the corner, if not already behind us, and Middle East or Caspian instability could sharply cut oil supplies. Historically, oil shortages and their concomitant rise of oil prices have always induced a recession. China 's growing dependence on oil ensures that should an oil crisis occur, it will slip into recession.
To summarize, the likely candidates for a trigger to the Chinese depression are (1) a worldwide currency, banking, or derivatives crisis, (2) a U.S. recession, (3) the containment of runaway inflation, (4) the disappearance of Chinese trade surpluses, and (5) an oil supply crisis.

Whatever the trigger of the bust in China , there is little doubt that this will provide the onset of a worldwide depression. Just like the U.S. emerged from the Great Depression as the unrivalled superpower of the world, so it is likely that China will emerge as the next. With a grain of salt.

Wednesday, September 08, 2004

Roach: Rebalancing or Relapse?

Keeping an eye on China.

An unbalanced world economy needs a new recipe for sustainable growth. A two-engine global growth dynamic has been pushed to excess. The over-extended American consumer can no longer carry the demand side of the equation. And an over-heated Chinese economy can no longer power the supply side. Nor can the world, as a whole, sustain the massive imbalances -- financial and trade -- that have arisen from this lopsided growth paradigm. But risks are building that a rebalancing may not go smoothly. As China and the US now slow, new growth engines must fill the void. Absent that important shift in the mix of global growth, the imperatives of rebalancing could well give way to a global relapse.

There can be no mistaking the disproportionate impetus that the US and China have provided to world economic growth in recent years. Over the 1996 to 2003 period, our estimates suggest that these two economies directly accounted for 49% of world GDP growth -- well in excess of their combined 33% PPP-based share in the global economy. Adding in the indirect effects due to trade linkages, and the total contribution could easily be in the 60-70% range. The US contribution shows up mainly on the aggregate demand front. Over the past eight years, growth in US personal consumption expenditures averaged 3.9% in real terms. That’s about one percentage point faster than trend growth over the prior 15 years and about 75% faster than the 2.2% gains elsewhere in the developed world. It is hardly an exaggeration to conclude that the American consumer has been the principal engine on the demand side of the global growth equation since 1995.

China has played an equally important role in driving growth on the supply side. Chinese real GDP growth averaged 8.2% over the 1996 to 2003 period -- more than three times average gains of 2.7% in the advanced nations and more than double average gains of 3.5% elsewhere in the emerging market and developing economies of the world. Yet the contribution of the Chinese producer is probably much greater than the GDP statisticians imply. Industrial output growth in China has averaged about 12% since 1995 -- fully 50% faster than gains in the official GDP growth metric. With a relatively undeveloped services sector -- less than 35% of Chinese GDP in 2003 -- and a relatively small consumption share -- 54% of Chinese GDP in 2003 -- surging industrial activity accounted for 54% of the cumulative increase in Chinese GDP since 1990. The impacts of this industrial-production-led strain of growth are global in scope. China now consumes a highly disproportionate share of worldwide demand for industrial commodities -- having accounted for 25-30% market shares in global consumption of aluminum, steel, iron, and coal in 2003. Moreover, China’s investment-led impetus resulted in a 40% surge in imports in 2003 -- underscoring its emerging role as a growth engine for externally-dependent economies such as Japan, Korea, Taiwan, and Germany. At the margin, there can be little doubt of China’s increasingly dominant role in driving the global production dynamic.

Both of these engines have now shifted to lower gears. Growth in US consumer demand moderated to a 1.6% increase in 2Q04, well below the 4.2% pace of the prior four quarters and the weakest quarterly performance in over three years. Largely reflecting this moderation, the consumption share of US GDP has receded from a record high of 71% in mid-2003 down to about 70%. While this is progress, it is only very limited, at best, in restoring some sense of balance to the US economy. From 1980 through 2000, the consumption share of US GDP averaged about 67%; by reversing only one percentage point of the recent four point overshoot, the American consumer has completed only about 25% of the journey on the road to normalization. A similar result is evident for the Chinese producer: Growth in China’s industrial output slowed to 15.5% in July -- a four percentage point reduction from peak growth rates of around 19.5% earlier this year. In my view, China needs to bring its production comparisons down into the 8-10% range in order to achieve a soft landing. The recent slowing of Chinese industrial output growth has achieved about 40% of the ten percentage point deceleration that a soft landing would require.

Downshifts in the US and China are now setting in motion the first phase of global rebalancing. Yet on both counts, as noted above, progress has been only limited -- the bulk of the slowing still lies in the future. Moreover, for both economies, the moderation of growth is largely a reflection of the internal dynamics of the business cycle. In the case of China, the downward impetus has come from a conscious shift to policy restraint in an effort to slow an overheated Chinese economy; this is critical to temper emerging imbalances that, if left unattended, could prove increasingly destabilizing in the future. Signs of such imbalances have been especially evident in the property markets of coastal China. They are also increasingly evident in the auto sector, where trade reports now suggest that inventories of unsold vehicles are piling up much more rapidly than the official figures suggest. With the Chinese slowdown having only just begun, senior Chinese officials have stressed recently that their commitment to a slowdown has now reached a “critical stage.” As policy restraint remains in place, China’s domestic investment should slow, tempering its supply-led impetus to global growth. A secular increase in Chinese export penetration is likely to be a partial offset.

For the American consumer, the recent moderation is less of an immediate response to policy restraint and more a by-product of the tough internal dynamics of an over-extended household sector. Nowhere does this show up more vividly than in the renewed sharp decline in the personal saving rate, which plunged to just 0.6% in July -- well below the already depressed post-1995 average of 2.7%. Lacking in job and wage income growth, consumers have drawn the bulk of their support from tax cuts and equity extraction from asset markets. However, with future tax cuts and sharp house-price appreciation unlikely, US consumers are likely to be increasingly mindful of depleted income-based saving rates. Add in a likely back-up in interest rates that should boost the carrying costs of record debt loads, together with sharply higher energy costs, and the squeeze on discretionary purchasing power could become all the more acute. While it’s always tough to bet against the American consumer, the noose finally appears to be tightening. I continue to believe that a US consumption adjustment will end up being the single most important source of moderation on the demand side of the US and global economy over the next couple of years.

Global rebalancing is not a one-way street -- it entails far more than just slowdowns in the US and China. Equally critical, in my view, is the renewal of growth elsewhere in the world -- namely, autonomous support from domestic demand, especially private consumption. On that count, the global economy remains woefully deficient. The Asian consumer is effectively missing in action. Thailand is perhaps the only exception, as consumption dynamics remain disappointing in most of the region -- especially in Japan, China, and Korea. For a while, there was hope that the Japanese consumer was about to awake from a decade-long slumber; however, with Japanese consumption now down for three months in a row in the period ending July 2004, those hopes have been all but dashed. Similarly, a likely popping of the Chinese property bubble spells new pressures on consumption trends in coastal China. And the Korean consumer is still reeling from the impacts of the bursting of credit and property bubbles in 2003. Nor is there much of an offset evident in Europe, where domestic demand continues to eke out relatively anemic gains. While that’s especially true in Germany, which makes up fully 30% of Euroland GDP, gains elsewhere in the region can hardly be described as vigorous. Europe is, at best, a 2% growth story over the next couple of years, according to the latest forecasts of our European economic team. If the US and China now slow, as I suspect, Europe is hardly capable of filling the void that could be left by the American consumer and/or the Chinese producer.

Partial rebalancing is a distinct negative for the global growth outlook. Our current baseline forecast calls for 4.7% growth in world GDP in 2004 -- the first year of above-trend growth in four years. However, we continue to expect that resurgence to be short-lived. Our 2005 forecast calls for global growth to decelerate to 3.8% --a slowing of nearly one percentage point from this year’s estimated gains and only fractionally above the longer-term 3.7% trend. Key to our slowdown call is likely deceleration in both the US and China. China and the US combined account for about 34% of total world GDP as measured on a purchasing power parity basis. US economic growth is expected to decelerate by 0.6 percentage point in 2005 (from 4.4% in 2004 to 3.8% in 2005) and Chinese economic growth is expected to slow by 1.5 percentage points (from 9.0% in 2004 to 7.5% in 2005). Collectively, projected downshifts in these two economies knock about 0.5% off world GDP growth in 2005 -- a direct effect of 0.35 percentage point and an indirect effect on other economies of about 0.15 percentage point. Consequently, if downshifts in the US and China are not countered by improved growth prospects elsewhere in the world, there is a distinct possibility of a major shortfall in global activity.

That takes us to the biggest risk of all: Any unexpected growth shortfalls could easily push growth in a still fragile world economy back into the 2.5% to 3.5% zone in 2005. Growth in that range would then leave the world dangerously near its stall speed and, therefore, highly susceptible to a shock. Recent developments on the energy front are especially worrisome in that regard (see my 20 August dispatch, “Oil-Shock Assessment”). With oil prices closing on $50, the risks of global recession were mounting. At $40, those risks would obviously be a good deal lower. The current price point of around $44 sits precariously between these two extremes. But whether it’s an oil shock or some other unexpected blow, the verdict is the same: With China and the US slowing and the rest of the world unwilling or unable to pick up the slack, a partial rebalancing could well heighten the possibility of a global relapse in 2005.

Keeping an eye on China.

Tuesday, August 24, 2004

The Nuclear Option [Financial]

The Nuclear Option
by Marshall Auerback

“Let us be blunt about it. The US is now on the comfortable path to ruin. It is being driven along a road of ever rising deficits and debt, both external and fiscal, that risk destroying the country's credit and the global role of its currency. It is also, not coincidentally, likely to generate an unmanageable increase in US protectionism. Worse, the longer the process continues, the bigger the ultimate shock to the dollar and levels of domestic real spending will have to be. Unless trends change, 10 years from now the US will have fiscal debt and external liabilities that are both over 100 per cent of GDP. It will have lost control over its economic fate.” – Martin Wolf, “America on the comfortable path to ruin”.

Martin Wolf succinctly points us to the crucial question preoccupying dollar bulls and bears alike: When will this haemorrhaging debtor nation be compelled to pull back from profligate consumption and resign its role as "buyer of last resort" for the global economy? Indeed, can it do so?

The US is clearly caught between the proverbial rock and a hard place. The expedient of dollar devaluation becomes problematic, given the extent of foreign ownership of US assets, which Bridgewater now estimates at 78 per cent of GDP (versus 33 per cent in 1990). Many of these foreign holders are creditors, who will not all take kindly to the notion of being repaid in substantially devalued dollars (Bridgewater also notes, for example, that foreigners’ purchases of US government securities has brought foreign ownership up to 42 per cent of the total Treasury market; excluding the US Treasuries held by the Fed, and this figure rises to 51 per cent). Against that, the extent of leverage in the domestic economy militates against the sort of rise in rates genuinely need to support and strengthen the dollar and thereby pay back these creditors in “honest dollars”.

This policy conundrum takes on added urgency in light of June’s horrendous trade deficit number of $55.8bn. Of particular note was that at $33 per barrel, the price of crude clearly did not reflect anything near current oil price levels, implying a further monstrous expansion of America’s external imbalances as the figures for July and August emerge.

Against that, international investors stepped up their purchases of US assets. Net purchases by foreigner rose to $71.8 billion from a revised $65.2 billion in May. Of the $71.8 billion that foreigners purchased, $40.5 billion of it was in Treasuries. In June Japan bought a net $21.2 billion of the Treasuries, while China bought a smaller amount. Japan is the largest foreign holder of US Treasuries, accounting for $689 billion, followed by China, which owns $164.8 billion.

The US economy, therefore, continues to be kept afloat by enormous foreign lending so that consumers can keep buying more imports, thus increasing the bloated trade deficits. This lopsided arrangement will end when those foreign creditors--major trading partners like Japan and China--decide to stop the lending or simply reduce it substantially.

It is well known that much of the source for that dollar buying today is the Asian official sector. As we noted last week, such huge purchases have prevented a calamitous fall in the external value of the dollar, which in turn has forestalled a private sector credit revulsion. Private sector creditors effectively view Asia’s central bankers as a bulwark against a precipitous dollar decline, given that their continued purchases of US dollars implicitly sanction the financial practices undertaken for decades by America’s monetary policy authorities and thereby ensure their perpetuation.

It is also true that central banks are not profit maximisers in the manner of a private business and are therefore perhaps happier to maintain the status quo – even if it means being repaid with devalued dollars – because the alternative is the loss of a huge export market and unprecedented financial instability, which central bankers abhor much as nature abhors a vacuum. To stop purchasing US dollars, it is said, risks the economic equivalent of embracing the nuclear option, a reckoning that could arrive as a sudden thunderclap of financial crisis—a precipitous withdrawal of capital a la Asia in 1997, which engenders a backdrop of spiking interest rates, swooning stock market and crashing home prices. Asia’s central banks, like US policy makers, may indeed recognise a self-interest in keeping the game going – avoiding a global meltdown that might ruin everyone.

But a closer examination of today’s capital flows suggests a new and potentially more disruptive class of investor who could easily bring down the whole house of cards on which American “prosperity” and the concomitant stability on which the dollar now rests. It’s not just central bankers who have a become a significant source of those capital inflows now providing offsetting support to a dollar otherwise bludgeoned by America’s growing trade gap. The Bureau of Economic Analysis is now including in its balance of payments figures data on broker/dealers in what used to only be bank data. The figures illustrate how banks and broker dealers have also become a major source for channeling money into the US. In the year ended March 2004, they added $251.7bn to their liabilities to non-residents, which in accounting terms constitutes a capital inflow into the US. These same organizations were channels for substantial inflows from Caribbean tax havens, likely representing foreign based hedge funds and proprietary traders, borrowing heavily in US dollars to fund carry trades in the US.

Although fund inflows from Asia (and by extension, the Asian official sector) continue to represent a substantial source of funding for the US, the BEA statistics, although not complete, do give us an alarming picture of a system increasingly dominated at the margin by leveraged financial flows, in an economy already dominated by massive debt accumulation: banks and brokers playing the carry trade, banks writing trillions of dollars worth of derivatives trades, and hedge funds borrowing like crazy in order to maximize returns. If the Greenspan Fed is serious about continuing to raise rates, then the cost of holding these positions becomes correspondingly greater. The margin clerks ultimately seize control, not the central banks. These sorts of leveraged flows are precisely the sort which could cut and run, precipitating the conditions for a violent fall in the dollar despite official sector efforts to the contrary.

Last year the US economy (business and households as well as the federal government) was compelled to borrow $540 billion from overseas creditors. Since the United States first became a debtor nation fifteen years ago, it has accumulated nearly $3 trillion in debt obligations abroad. At the current pace, the foreign debt load will double again in the next six or seven years.

This position severely compromises latitude in policy making. It seems highly improbable to imagine that the fiscal expansion can be continued much longer, taking the budget deficit and government debt into hitherto uncharted territory. Even if the fiscal deficit rises no further the present rate of deficit implies a rise of public debt toward 100 per cent of GDP, notes Wynne Godley of the Cambridge Endowment for Research in Finance. Private expenditure can hardly remain a sustainable long term engine for growth given that personal savings remain non-existent and personal expenditure is being perpetuated by further increases in debt. So American growth in the medium term looks increasingly dependent on rises in net exports which, given the increasing size of the trade deficit, implies a substantial further dollar devaluation (especially since the declines sustained thus far have done nothing to reduce the current account deficit).

Never have the imperatives of American economic policy making been so hamstrung by the realities of external debt build-up. The humbling reality is that across three decades, only one economic event has been guaranteed to produce a more balanced US trade picture: a recession. When the economy is contracting, people naturally buy less of everything, including imports. At the very least, US policy making ought to be geared toward the restriction of domestic demand through repeated interest rate rises.

But the realities of a hugely leveraged economy make this a highly perilous exercise. The markets had a brief taste of it felt like to be at the receiving end of de-leveraging earlier this spring, when the first phase of unwinding the “Great Reflation Trade” took place. Anyone holding gold, commodities, euros, Australian and New Zealand dollars, or China H shares was slaughtered, as the most tenuous portions of this trade came unglued. The base and precious metal drops were particularly dramatic, even though the economic backdrop remained ostensibly supportive of synchronized global growth and hence “reflation plays”.

But as the experience of April demonstrated, it is of the nature of crowded, leveraged trades that when players try to exit, they find massive illiquidity in the exposure they are trying to reduce. Loss control then requires they sell an asset that is more liquid or less compressed in price. Through such channels, behavioral finance tells us to expect contagion effects between seemingly unrelated financial markets. As contagion effects amplify the initial loss control attempts, and liquidity preferences surge en masse, cascading markets can result. This, for example, is what we saw in the LTCM debacle of late 1998. This same kind of de-leveraging effect can ultimately impact on the US dollar and credit system, and given the apparent size of the broker/dealer positions in the market (and the corresponding leverage), a collective rush to the exits by these players could easily overwhelm the best intentions of the Asian official sector.

At this point, even the intentions of the central banking fraternity might change. Seeing the US gradually collapsing at the core, their major export market at risk, Asia’s central bankers might well opt for a strategy of self-preservation, or use the region’s savings surplus at home in order to stave off contagion effects from the US. Under such circumstances, American monetary and fiscal policy makers will have little in the way of negotiating leverage, given the extent to which the country is already at the mercy of its foreign creditors. The consequences will be especially severe for the less affluent--families already stretched by stagnating wages and too much borrowing.

The moral hazard dialectic of remedying successive crises in an ever more fragile financial structure with bailout measures is coming home to roost. Against a backdrop of historically unprecedented current account deficits, the ability of American policy makers to deal with the economic fall-out were the “nuclear option” of massive capital withdrawal to be activated is minimal. Ultimately, the global economy will have to deal with the “nuclear fallout”. The transition will undoubtedly be unsettling, even dangerous, particularly as the declining economic power also happens to be the pre-eminent military power. An American reckoning is going to have consequences for the entire world, but harshest consequences will likely be experienced by US consumers. The vast majority in the country will experience a major decline in their living standards to a degree unprecedented since the Great Depression. This will be remembered as the true legacy of the Greenspan Federal Reserve. The Nuclear Option