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.

The U.S. Current Account

Lawrence Summers is finally catching up to what I wrote him about in the nineties. Article by Marshall Auerback.
Roach, on why the dollar should be lower.
Another currency view by Willia Pesek Jr.
The US as a Net Debtor:The Sustainability of the US External Imbalances - Nouriel Roubini - Stern School of Business, NYU and Brad Setser - Research Associate, Global Economic Governance Programme, University College, Oxford
Lawrence Summer's official speech.

The Trade Wildcard

Stephen Roach on trade and politics. The warnings are getting louder - beware!
Bob Hoye on Political and Monetary Reform - This is general but well worth the read.
Auerback on - A Clear Mandate (But Will The Foreign Creditors Go Along)

America - Bye, Bye!

Here's a poem to cheer you up - or down?

The Gloomy World of 2008

Auerback - The Global Economy

A Global Growth Inflexion Point?
Dollar Stumbles
Roach - Cracked Facade
Norwegian oil production faces total paralysis after lock-out threat

Auerback On Euroland

Euroland + Turkey?
Daniel Lian on Thaksinomics

Roach - Global: Danger Zone

A warning from an ex-fed member - deflation.

Auerback - The Dollar/Yuan Question

Guess Who’s Coming To Dinner?
Roach - Canary in the Coal Mine
Sino Hollow - Daniel Lian

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

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.

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 (http://www.pbc.gov.cn/english/baogaoyutongjishuju), “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.

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.

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

Twin Deficits at the Flashpoint

Twin Deficits at the Flashpoint
by Stephen Roach

June’s enormous US trade deficit should be a wake-up call to America and the rest of the world. It is a direct manifestation of a lopsided global economy that remains biased toward unprecedented external imbalances. As long as the US continues to live well beyond its means and as long as the rest of the world fails to live up to its means, this seemingly chronic condition will only get worse. The imperatives of global rebalancing are reaching a flashpoint.

America’s record $55.8 billion trade deficit in June was a shocker. Annualized, it is equivalent to a $670 billion shortfall, or 5.75% of nominal GDP. Nor can this deterioration be explained away by surging oil prices. Excluding petroleum products, the trade deficit for goods still widened by $2.7 billion in June -- an enormous swing by any standards. The plain fact of the matter is that America has never come close to running such an outsize external deficit before. By way of comparison, the last time the US had a “foreign trade problem” was in the latter half of the 1980s; back then, the trade deficit (as measured on a national income accounts basis) peaked out at 3.2% of GDP in the second quarter of 1987. Needless to say, that was not the most tranquil of times in financial markets. As America’s external imbalance widened in mid-1987, the dollar came under sharp downward pressure and US interest rates were pushed higher. Those were the classic manifestations of a current account adjustment that many (myself included) believe were at the heart of the stock market crash of October 1987. Today’s external imbalances dwarf those of 17 years ago.

It’s easy to point the finger at others in diagnosing the problem. In the political season, the blame game always intensifies. US Treasury Secretary John Snow blames it on new weakness in the global economy. The Democrats tie America’s trade and jobs problems to the pressures of outsourcing and unfair foreign competition. As usual, there are some elements of truth in both explanations. The global economy does, in fact, appear to be sputtering. Goods exports plunged by 5.9% in June (in real terms), the largest monthly decline on record. While month-to-month fluctuations can never be taken too seriously, I don’t think it’s a coincidence that such a sharp decline in overseas shipments of American made goods occurred as slowdowns became increasingly evident in China and Japan and sluggishness persisted in Europe. On the other side of the trade ledger, renewed sluggishness on the US job front and a 1.8% surge in non-petroleum imports in June (sequential monthly rate) certainly speak to the unrelenting pressures of foreign penetration into US markets.

Yet this finger pointing misses the basic problem -- that of a saving-short US economy that is locked into the destructive spiral of ever-widening twin deficits. Lost in all the shuffle was the latest monthly update on that “other deficit” -- a $69.2 billion shortfall in the July federal budget deficit reported last week by the US Treasury. Not only was that about $7 billion worse than expected, but it puts America easily on track to break the $400 billion threshold on the budget deficit for the first time ever. While America’s budget deficit has been larger as a share of GDP -- the estimated 3.6% gap in the current fiscal year falls well short of the 6% peak hit in 1983 -- the sheer volume of financing is obviously of critical importance for the capital markets. Nor has the US ever experienced such a massive turnaround in its budget position -- with the deficit for the current fiscal year representing a swing of 7% of GDP relative to the 2.4% budget surplus recorded in 2000.
Moreover, there’s another key aspect of this problem: Unlike the deficits of the 1980s, America is lacking in any backstop in private saving. Net of depreciation, the private saving rate of households and businesses, combined, stood at just 4.5% of national income in 2003; that’s only a little more than half the 8.3% average recorded in the latter half of the 1980s -- the last time the US had a deficit problem. In addition, the personal saving rate fell back to just 1.2% in June 2004 -- underscoring the asset-dependent US consumer’s seemingly chronic aversion to income-based saving. This deficiency of private saving means that outsize government budget deficits are now putting a greater strain on the US economy and financial markets than was the case during the latter half of the 1980s.

This lack of saving, in my view, is America’s most vexing problem. Adding in government deficits, the net national saving rate -- the combined saving of households, businesses, and the government sector adjusted for deprecation -- has averaged only about 3% since 2000. By way of comparison, the net national saving rate averaged nearly 10% in the 1960s and 1970s before falling to 5.9% in the 1980s and 4.8% in the 1990s. Lacking in domestic saving, the United States has no other choice than to import foreign saving from abroad -- and run massive current-account and trade deficits to attract that capital. To the extent that the extraordinary deterioration in the federal budget has been the main culprit in pushing down America’s domestic saving rate in recent years, the two deficits are joined at the hip. Without a cushion of private saving, a long-term structural budget deficit problem -- precisely the outcome the US now faces, according to the non-partisan Congressional Budget Office -- spells unrelenting pressures from America’s twin deficits for as far as the eye can see.

This is not a message that plays well in Washington. Believe me, I know that -- having testified many times in front of the US Congress on one of these deficits or another. Politicians, in their never-ending search for both the scapegoat and the quick fix, are hardly predisposed to looking in the mirror and accept any blame for the recent deterioration in national saving and the current-account and trade deficits it spawns. Pete Peterson makes that same point eloquently in his latest book, Running on Empty (Farrar, Straus and Giroux, 2004). The subtitle of this tome says it all: Both the “Democratic and Republican Parties are Bankrupting Our Future.” I couldn’t agree more -- especially with the ever-ticking demographic clock calling out for an increase in national saving at precisely the time when America is going the other way. Yet deficit reduction never sells on the campaign circuit, regardless of the mounting perils of a saving-short economy. Campaign 2004 is no different in that respect. Senator Kerry and President Bush are arguing more over the types of additional tax cuts America needs rather than debating the imperatives and tactics of deficit reduction.

Maybe June’s trade deficit is a wake-up call. If so, it will be up to financial markets to send that message. That was the verdict in October 1987 and it may well be the case again. Financial markets have long served the painful but useful purpose of venting imbalances in the real economy. No two such episodes are alike, however. Just because the tensions of America’s twin deficits in 1987 were vented in equity markets doesn’t mean the same such phenomenon will necessarily occur in 2004. Other asset markets could just as easily give way -- the dollar, the bond market, credit markets, or even property. Nor is the recent slide in the US equity market inconsistent with the outcome that might be expected in a more full-blown current account adjustment.

The point is that a chronic twin-deficit problem in a saving-short US economy requires ever greater volumes of capital inflows into dollar-denominated assets in order to finance ongoing growth in the domestic economy. As the current-account gap -- the broadest measure of international transactions -- rises toward 6% of GDP, America will need to import in excess of $2 billion in foreign capital each and every business day of the year. Up until now, that financing has occurred on terms that are very favorable to the United States -- there has been only a limited decline in the broad dollar index and virtually no increase in real long-term interest rates. In the end, however, a chronic shortfall of national saving cannot be financed indefinitely without consequences. Barring a sudden improvement in the national saving outlook, underlying asset values in the United States must be written down to match the ensuing reduction in this saving-short economy’s intrinsic growth potential. That’s where pressures on asset prices come into play.

Never before has the world’s dominant economic power lived this far beyond its means. Most believe that America is special -- that it deserves special dispensation from current account, debt, and saving adjustments. Just as history is littered with the remnants of other such new paradigms, I continue to believe that the United States will have to pay a steep price for its imbalances. As America’s twin deficits move inexorably toward the flashpoint, there is a growing risk that its external financing terms could take a sudden turn for the worse. The dollar, US equities, and credit markets strike me as most vulnerable to such a development. Twin Deficits at the Flashpoint

International Trade's True Picture

Doha is a Phoney Bill Of Goods 
By Marshall Auerback 

“The rules for admission into the world economy not only reflect little awareness of development priorities, they are often completely unrelated to sensible economic principles. For instance, wto agreements on anti-dumping, subsidies and countervailing measures, agriculture, textiles, and trade-related intellectual property rights lack any economic rationale beyond the mercantilist interests of a narrow set of powerful groups in advanced industrial countries.” – Dani Rodrik, “Trading in illusions,” Foreign Policy (123) March/April, 2001
 
The Doha round of multilateral trade negotiations is, yet again, on the brink of failure. We are told that a failure to resolve ongoing tensions between the developed and developing world will engender a collapse of free trade and a corresponding reduction in economic growth, particularly ominous given the apparent slowdowns increasingly manifesting themselves in the US and China.
 
Not so fast.  The doomsayers largely predicate their negativism on the so-called “Washington consensus” school of thought, which holds that the only viable option for developing countries is maximum integration into the world economy plus domestic reforms to stabilize integration and make domestic markets more efficient (including “good governance” reforms to bring the poor into the process). Sectoral-industrial policy, and anything intended to foster nationally controlled industries over foreign-owned, or to transfer technology beyond the speed desired by private foreign firms, is out.  It seems to us that this line of thinking has little to do with free trade and much to do with an increasingly discredited ideology that has done much to impoverish both American workers and the developing world it purports to help.

Within the realms of policy making and academia, there are finally some challenges being proffered in opposition to the market fundamentalism embodied in the Washington Consensus.  In recent co-authored work, Joseph Stiglitz, the former chief economist of the World Bank, argues that the development focus of the Doha round is a myth. He wrote in the FT on June 21: "Recent negotiations have not only failed to push an agenda that would promote development; they have included a host of issues that are of tangential interest, or even detrimental, to developing countries."

A real development agenda, argue Prof Stiglitz and Andrew Charlton, the Oxford economist, would be very different from the one on offer at the current talks. Above all, they argue, “trade negotiations must begin from the premise that the less developed countries are deserving of special and differential treatment, both because they have been disadvantaged in the past and because of differences in their current circumstances. This will entail a movement away from the principles of reciprocity and bargaining…It will entail unilateral concessions by the developed countries, both to redress the imbalances of the past and to further the development of the poorest countries of the world.”

The views of Stiglitz and Charlton may seem heretical to free trade ideologues, but their notions of special and differential treatment are consistent with successful growth strategies adopted by virtually every developing economy.  Britain was protectionist when it was trying to catch up with Holland. Germany was protectionist when trying to catch up with Britain.  Japan was protectionist for most of the twentieth century up to the 1970s, Korea and Taiwan to the 1990s. Hong Kong and Singapore are the great exceptions on the trade front, in that they did have free trade and they did catch up—but they are city-states and not to be treated as economic countries. By and large, countries that have caught up with the club of wealthy industrial countries have tended to follow the prescription of Friedrich List, the German catch-up theorist writing in the 1840s: “In order to allow freedom of trade to operate naturally, the less advanced nation [read: Germany] must first be raised by artificial measures to that stage of cultivation to which the English nation has been artificially elevated.”
 
Within the “transitional” countries (moving from communism to capitalism) the comparison between Russia and China provides the extreme case in point: Russia—massive liberalization and privatization (shock therapy), catastrophic economic performance; China—gradual liberalization and privatization, excellent economic performance (by standard measures). Within each region (central Europe, southeastern Europe, the former Soviet Union, East Asia), one finds that the more radical liberalizers performed worse economically in the 1990s than those that moved more gradually. Even in countries of comparable economic development and maturity, the claims made on behalf of economic liberalization per se ring rather hollow:  From 1984 to the late 1990s the New Zealand government undertook much more radical liberalization than Australia’s, and economic performance has been substantially worse.
 
The US itself embraced a more classically “protectionist” or “developmentalist” strategy in its early post-colonial phase. Alexander Hamilton, the first U.S. Secretary of the Treasury (1789–95), set out a strategy for building up American industry behind tariffs to the point where American manufacturers would be able to compete against foreign competition unaided, in Reports of the Secretary of the Treasury on the Subject of Manufactures, 1791.  The United States followed a protectionist industrial strategy for most of the period from then right up to the early post–World War II years, when U.S. industry had achieved supremacy. Only at this point did the U.S. government begin to champion free trade. Ironically, this is doing little for the American economy today, yet a resort to outright protectionism will likely doom the country to a bout of capital flight.

Washington has been hoisted on its own petard.  Policy makers have embraced an unthinking acceptance of “free market” globalization.  The reality, however, is that America has becoming a hemorrhaging debtor nation compelled to retain its role as “buyer of last resort” for the global economy, even as it totters on the threshold of true bankruptcy.  The facts are not secret. Despite ebbs and surges, the gap between US exports and imports has been steadily widening across three decades.  The trade deficits of the early 1970s (due mainly to soaring oil prices) were trivial in size, but Americans were shocked in 1978 when the deficit hit $30 billion in one YEAR (TV sets and some cars were now made in Japan).

Needless to say, things have progressively worsened:  During the 1980s, the trade deficit expanded enormously, as Washington's strong- dollar policy crippled US manufacturers and companies moved jobs and production offshore in swelling volume. After a recession and dollar devaluation, the gap shrank briefly, but soon began expanding again.  For all of the positive spin placed on the latest monthly trade deficit figure of $46bn, this is still one of the highest monthly figures in history.  Annualized, it would still place the US perilously closer to third world debt trap dynamics.

American leaders and policy-makers remain uniquely dedicated to a faith in “free market” globalization, and they have regularly promised Americans that despite the disruptions, this policy guarantees their long-term prosperity. Present facts make these long-held convictions look like gross illusion. By 1998, the trade deficit was back to a new high and expanding ferociously, despite supposed improvements in US competitiveness. Last year it set another new record: $489 billion.

The latest Doha round will not solve this problem, nor will it do anything for the so-called “G-90” developing nations, which are mounting an increasingly unified and sophisticated campaign against what is on offer in the latest round of trade negotiations.  Indeed, to describe these talks as “free trade” negotiations is Orwellian sophistry at its finest.

Lowering tariffs and other trade barriers have been a minor aspect of global trade negotiations or any bilateral U.S. trade agreements such as those between the US and Chile and Singapore respectively (which place much more focus on the issue of free moving capital, in effect attacking the symptom of the current problem, namely America’s growing dependency on foreign capital flows as a consequence of decades of misguided trade policy). If free trade were the only purpose of these trade pacts, the agreements could be written on a few sheets of paper. Instead these deals fill large volumes. They contain chapter after chapter setting strict rules governing the treatment of investment, capital account convertability, and other areas of commercial law.

One of the main purposes of these agreements has been to impose U.S.type laws governing intellectual property claims (patents and copyrights) on nations throughout the world. The United States has used its full diplomatic and economic power to get nations from Latin America to China to respect U.S.-type laws in these areas. These laws are gross intrusions into the workings of a free market. As a result of this form of government protection, books, movies, music, and software that could be produced at virtually zero cost are instead sold at hundreds or even thousands of times the cost of production. (There are far less intrusive ways to finance the intellectual and artistic work that produces this material.)  It may be perfectably supportable to support intellectual property in this manner, but those who do so must also recognise the inherent contradiction whereby it is deemed perfectly acceptable to impose the big regulatory hand on foreign governments in order to enforce Microsoft’s intellectual property rights, but antithetical to free trade to enforce minimal environmental and labor standards on the developing world. 

This double-standard is not addressed in the most recent round of negotiations at Doha.  Indeed, high tech in particular seems to be accorded particularly sacrosanct protected status.  Any attempts by the developing world to nurture new industries and new technologies and to diffuse innovations to established industries—that might have the unwanted consequence of raising the competitive pressure on industries in the industrialized countries are frowned upon most severely.

Similarly, “free trade” is not interpreted as meaning that bright students from Mexico, India, China, and elsewhere will be able to come to the United States to finish their education and compete on an even footing with our doctors, lawyers, accountants, and other highly paid professionals. The immigration and professional licensing restrictions that rule out this competition are rarely serious topics of trade negotiations, especially post 9/11.

“Free trade”, therefore, has come to mean having U.S. manufacturing workers compete against the poorest workers in the developing world, while highly paid professionals remain protected, and the concept of “intellectual property” is used to restrict flows of commerce around the world.  Capital, on the other hand, is not to be restricted at all, despite the fact that most developing nations have been adversely affected by the premature removal of restrictions on free capital mobility, legitimized by the U.S. Treasury and the imf.  
 
Taken in aggregate, the WTO, as currently constituted, neither helps US workers (who find themselves persistently subject to wage pressures as more and more compete against the poorest workers of the world), nor the developing countries, which are precluded by the same rules to enable their governments to pursue most of the industrial policies successfully implemented in East Asia.  In the words of Professor Robert Wade from the London School of Economics:
 
“Before the Uruguay Round (1986–94) the international trade regime recognized the right of ‘special and differential treatment’ for developing countries, and allowed this to qualify the basic norm of  ‘no discrimination’ (no discrimination between suppliers based in different countries, as in the ‘most favored nation’ principle). At that time the policies of developing country governments and the thrust of multilateral trade and investment negotiations concerned the terms on which goods from developed countries would get access to developing country markets. But during the Uruguay Round and the negotiations of the three capstone agreements—the Trade-Related Intellectual Property agreement (trips), the Trade-Related Investment Measures agreement (trims), and the General Agreement on Trade in Services (gats)—all this changed.
 
The agreements at the end of the Uruguay Round represent a basic change of norms governing world trade. ‘Reciprocity’ eclipsed ‘development’; or more exactly, ‘reciprocity,’ ‘uniform rights and obligations,’ and ‘all countries (except the smallest and poorest) as equal players’ eclipsed ‘special and differential treatment for developing countries.’ At the same time, the earlier norm of ‘no discrimination’ between national suppliers became the norm of ‘no (trade and investment) distortions.’  The ‘no distortions’ rule makes it against wto rules for a government to use policies that “distort” trade and investment flows—including performance requirements on incoming foreign direct investment (such as local content requirements, trade balancing requirements, export requirements, technology transfer requirements, r&d requirements, joint venturing requirements, public procurement tied to local suppliers, and the like).  As a specific example, Article 27.1 of the trips agreement says that a ‘patent shall be available and patent rights enjoyable without discrimination as to … whether products are imported or locally produced.’  This makes it illegal for a government to curb a patent for a product whose domestic production the government wishes to encourage but whose producer refuses to establish a local production facility, thus blocking the process of import replacement.” – Governing the Market, Creating Capitalisms: Introduction to the 2003 Printing.    
 
From this set of premises, the whole process becomes a “heads I win, tail you lose” proposition for the developing world.   So when commentators, such as Martin Wolf dispute the notion that demands for liberalization by developing countries are economically harmful, he is only looking at this issue within the narrow confines of free trade parameters traditionally designed by the apologists for organizations such as the WTO, rather than looking at the broader issues raised by Wade and others.  Wade’s work in “Governing the Market” provides ample illustrations which refute the notion that the creation of efficient, rent-free markets coupled with efficient, corruption-free public sectors is even close to being a necessary or sufficient condition for a dynamic capitalist economy.  His book provides numerous examples to show how all now-developed countries went through stages of industrial assistance policy before the capabilities of their firms reached the point where a policy of (more or less) free trade was declared to be in the national interest. 
 
And, in the greatest irony of all, today’s “free trade” is doing nothing to help the US economy in slightest, except insofar as any future “trade liberalization” agreements enshrine America’s ability to satisfy its unremitting reliance on capricious, unregulated global capital flows.  Perhaps, therefore, the collapse of Doha is what is required in order to devise a development/growth agenda focused on creating capitalist systems able to generate mass affluence and a decent quality of life, whilst discarding this misplaced economic shibboleth that, liberalization, deregulation, strengthening participation and eliminating rents and corruption is all that is required to get us all back to the road to prosperity. ...Link