The Perils of Protectionism - Currency Visions
...In the meantime, the clock continues to tick away, punitive tariffs are about to be introduced, and America remains highly dependent on US speculative capital flows. The “deficits don’t matter” apologists would have us believe that this is irrelevant, so long as the US continues to provide superior returns to capital, even if such capital is highly speculative in nature.
The traditional repast to any of us who raise questions about the “virtues” of unbridled speculation can be found within the so-called “Chicago School”, where speculation is viewed as fundamentally stabilising (Friedman, 1953). This Chicago point of view is predicated on the argument that there exists a market price which is warranted by economic fundamentals. When the actual price exceeds this warranted price, speculators realize that the market is over-valued. They therefore sell, and drive the market down to its warranted price. Conversely, when the actual price is below the warranted price, speculators realize the market is under-valued. They therefore buy and drive the market up to the warranted price.
This argument can be challenged in a number of ways. One challenge comes from the Chicago School’s own rational expectations theory of behaviour which shows how asset price bubbles can be rationally self-fulfilling. All that is needed is that market participants expect that the future price will be higher, and they will then buy now on anticipation of this higher future price. In this fashion “market beliefs” become the driving fundamental, and if speculators share and shape this belief they can drive prices away from the level warranted by economic conditions. In effect, one has what Lawrence Summers once described as “rational destabilising speculation”.
More importantly, the Chicago school’s benign view of speculation does not appear to have been borne out by the history of financial markets over the past few decades. In 1994 Mexico was hit by a major financial crisis. Not only did this crisis hurt the Mexican economy, it also hurt all of Latin America which was infected by a process of financial contagion (the “Tequila” effect). In 1997 financial crisis again erupted in East Asia, this time pulling down the economies of South Korea, Thailand, Indonesia, and Malaysia. In 1998 Russia was hit by financial crisis, and this was followed by a financial crisis in Brazil in 1999. The belief is that all of these crises were either triggered or exacerbated by financial speculation, and that measures to reduce speculation, such as capital controls (introduced by Malaysia, for example, in 1998) would have helped avoid the crises or reduced the extent of resulting damage.
It is not only developing countries that have been hurt by currency speculation. Developed countries, including the U.S., have also been injured. In the wake of the Russian financial crisis of summer 1998, Wall Street was rocked by a crisis of its own. The Russian crisis generated a wave of unpredictable movements in interest rates which pulled down the hedge fund Long Term Capital Management (LTCM). The crumbling of LTCM’s financial position in turn threatened to pull down the entire market owing to the extent of LTCM’s borrowings and the exposed nature of its financial positions, and this necessitated the Federal Reserve intervening to co-ordinate a private sector funded bailout of LTCM.
U.S. manufacturing industry was also badly injured by the East Asian financial crisis. U.S. exports to the region fell as East Asian currency values plummeted relative to the dollar and East Asian economies went into recession, while U.S. imports from the region surged. The result was a massive increase in the U.S. trade deficit that was accompanied by the loss of half a million manufacturing jobs and a huge loss of future trade competitiveness, the full effects are being manifested today in the form of a hemorrhaging trade deficit and yet more reliance on the very sort of speculative capital that wrought so much havoc on the economies of the emerging world. Ironically, in pursuing a more protectionist agenda, the US risks bringing on an Asian-style financial crisis.
Protectionism, however, attacks the symptoms, rather than tackling the underlying problem of US competitiveness. In the 1980s, the US dollar soared against the currencies of Europe and Japan and subsequently crashed against these same currencies. Many emerging nation currencies stayed linked to the dollar, at least in real terms. In any case, at the time the emerging world was a far less important part of the global economy and US trade than it is now.
With its embrace of a strong dollar policy during the latter part of the 1990s, a conspicuous feature of this cycle has been the rise in the real value of the dollar against the emerging world – particularly emerging Asia – in spite of mounting external indebtedness (the normal solution for which would be devaluation). This is in sharp contrast with the past, when higher domestic inflation plus a fixed real exchange rate caused the nations of emerging Asia to experience an ongoing real appreciation of their currencies against the dollar. This real appreciation partially offset their rapidly improving abilities to compete with the US in more and more markets. The resultant improvement in American competitiveness in turn enabled the US to improve its current account position and thereby forestall growing protectionist sentiment.
By contrast, since the Asian financial crisis, despite continued higher increases in productivity in tradeables relative to the US, these countries have undergone massive devaluations against the dollar. Even with the strong economic recoveries from the crisis-induced lows of 1998, these countries’ currencies still linger well below levels sustained throughout most of the early 1990s, as they persist in neo-mercantilist policies to ensure that they never again run large current account deficits (and thereby expose themselves to volatile Western portfolio capital flows). And in some instances, such as China, Malaysia and Hong Kong, the countries concerned have directly pegged their currencies against the dollar and are therefore now reaping yet further competitive benefits as the US has shifted away from its strong dollar policy.
We have always believed that this huge departure from the trend path of these currencies would create the potential for quantum increases in competitiveness at the expense of the US and the continuing deterioration of the American trade account seems to bear this out. The misplaced focus on Asia’s alleged “unfair trading practices” or China’s “undervalued currency” is akin to the carrier of a disease blaming the infected recipient.
Consider the case of Malaysia. Malaysia's gross domestic product expanded by 5.2 per cent last year, making it the third fastest growing economy in south-east Asia after Thailand and Vietnam.
The growth rate, released last week, exceeded a government forecast of 4.5 per cent but was in line with market expectations. It was the economy's best performance since 2000. It posted 4.2 per cent growth in 2002. Growth in the fourth quarter accelerated to 6.4 per cent, after a revised 5.2 per cent rate in the third quarter, due to increased electronics exports. Exports have clearly been helped by Malaysia's currency peg to the US dollar.
Today’s American protectionists would undoubtedly proclaim (as they do with China) that Malaysia has achieved an “unfair” trade advantage through the deliberate embrace of an “undervalued” currency by virtue of its maintenance of the peg against the greenback. What they forget is that the imposition of this currency peg was a direct consequence of the country’s ultimately successful battle against speculative capital flows during the 1997/98 financial crisis. The deterioration in of America’s trade balance, and corresponding rise in protectionism that it has engendered in US policy circles, in effect represents economic blowback from that period.
As we come into the 21st century, it is said that the US has largely become a service economy, although as the President’s chief economic advisor, Gregory Mankiw, has noted, such neat distinctions are becoming increasingly hard to make. Even whilst broadly conceding Mankiw’s point, it is also clear that the embrace of a strong dollar policy in effect wiped out the last vestiges of serious American manufacturing. This has left the US with an economy increasingly dominated by services firms, which are now responding to these profound competitive pressures by outsourcing. Outsourcing is also a logical consequence of this loss of US competitiveness. It has aided the service sector’s ability to deal with stubborn cost pressures such as benefits cost inflation (medical and insurance being two of the biggest). Those politicians who would block this avenue for cost containment are implicitly forcing the service industry to find other mechanisms for generating these same cost savings, or else lose their profit margins.
One possible response if “outsourcing” becomes too hot a political issue is more aggressive domestic labour cost squeezes, which would likely mean lower aggregate service employment levels, greater reliance on temps (for whom benefits are not an issue), more severe limitations on benefits for those who remain on the payroll, and so forth. The result would be a further rise in the percentage of US working-age people who either lack benefits or whose access to good private sector benefits is restricted to a greater degree. For an economy already reaching the limits of sustainable domestic demand, this would be a recipe for disaster in terms of its future implications for US consumption.
When the financial health of a nation shifts as dramatically as it did in the United States from 1996 to now, the recent past seems not so much gone as completely transformed. Comfortable government surpluses and millions of jobs have abruptly vanished almost as though they never existed. And yet the US still conducts trade policy as if it were 1996 all over again, treating its creditors like vassals, whilst failing to recognise the grave economic vulnerabilities it now faces. The classic remedy for a chronic balance of payments problem, as the US has today, is a steady devaluation of the currency. But for this policy to be successful, it presupposes that the “right” counterparties can be found against which one can devalue. As the Malaysian experience demonstrates, that is easier said than done. But can one really blame Malaysia, which adopted a currency peg as its sole defence against the depredations of speculative global capital? Devaluation also presupposes an embrace of open markets which, for all of the sins of the previous Clinton administration, was pursued in a more consistent manner than the Bush Presidency has done.
Of course, it is also conceivable that the dollar bear market has run its course, in which US authorities seriously have to worry, since there is little else that can be achieved in the way of policy stimulus to sustain current growth. On the other hand, were the dollar’s devaluation to continue ultimately, the presumed improvement to external trade could be undermined by the persistent resort to trade protectionism. The US may, as a last gasp desperate measure, make use of non-selective tariffs conditionally under Article 12 of the World Trade Organisation, but this recourse to protective tariffs (tried – and failed – under steel) would more likely do more to highlight the country’s precarious economic position, thereby triggering precisely the sorts of capital flight that it has so far conspicuously managed to dodge. It would indeed be ironic if this speculative flight was triggered by America’s own championing of what it has long opposed – a persistent resort to trade protectionism, but the country is clearly closer than ever to reaping what it has sown in economic policy. ...Link
Wednesday, March 03, 2004
Auerback's Segacious Perception
Marshall Auerback has really hit the nail on the head with this article. He correctly points out the faults of the Chicago classical school's ideas about speculation as well as the failure of freely floating exchange markets. The dollar is now devalueing against the wrong nations' currencies - the wrong nations. We are more than certainly headed into an untenable mammoth global currency crisis. How long do you suppose it's going to take the classical schools to awake? My main point is as Marshall's is, ie., you can't have the floating developed nations in currency battle while the fixed currency nations reap the benefits of our blindness of adjustment and balance impossibilities, under their false abstract thinking. The classicals still believe in failed Samuelson/Friedmanism while much of the world markets have moved to crude Keynesianism/Schachtianism. How much shock and debt do you suppose we'll pile up befor the Rip-Van-Winkle right opens its eyes? Time for Keynes' `True Middle Way' - Exchange Clearing?