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January 17 2010

Exchange Rate Orthodoxy and the ECB

Is continental Europe repeating mistakes made in the 1930s?:

Ominous lessons of the 1930s for Europe, by Paul De Grauwe, Commentary, Financial Times: The Great Depression taught us several lessons. ...  There is one area of policymaking where authorities may not have learned the lessons of history... During much of the 1930s ... the so-called gold bloc countries (France, Italy, Belgium, the Netherlands and Switzerland) kept their currencies pegged to gold. When in the early 1930s Great Britain and the US went off gold and devalued their currencies, the gold bloc countries found their currencies to be massively overvalued. This had the effect of depressing their exports and of prolonging the economic depression in these countries.
It is remarkable to see ... the same mistakes ... today involving some of the same countries... This time it is again the continental western European countries tied together in the eurozone that have seen their currency, the euro, become strongly overvalued. The two countries that in the 1930s responded to the crisis by devaluing their currencies, the US and the UK, today have also allowed their currencies to depreciate significantly ... against the euro...
Why do the euro area countries repeat the same policies as the gold bloc countries in the 1930s? The answer is economic orthodoxy. In the 1930s it was the orthodoxy inspired by the last vestiges of the gold standard. Today the economic orthodoxy that inspires the European Central Bank is ... the view that the foreign exchange market is better placed than the central bank to decide about the appropriate level of the exchange rate. A central bank should be concerned with keeping inflation low and not with meddling in the forex market. As a result, the ECB has not been willing to gear its monetary policy towards some exchange rate objective.
Just as in the 1930s, the euro area countries will pay a price for this orthodoxy..., a slower and more protracted recovery from the recession. ... One could object ... that the central bank is powerless to affect the exchange rate. This is a misconception. A central bank can always drive down the value of its currency by a sufficiently large increase in its supply. ... True,... the ECB has injected plenty of liquidity in the euro money markets to support the banking system. Yet it has been much more timid than the US Federal Reserve and the Bank of England... Such an imbalance in the expansion of central bank money inevitably spills over in the foreign exchange markets. ...
Ultimately a central bank has to make choices. The Fed and the Bank of England have opted for massive programmes of liquidity creation, attaching a low weight to the possible inflationary consequences... The ECB has been more conservative... The future will tell us which of these choices was right.

January 03 2010

''Almost Nobody ... Put the Pieces Together''

Paul Krugman says "Even those of us who diagnosed that housing bubble correctly failed to foresee the financial implosion that would follow. ... How stupid of me!"

January 01 2010

Paul Krugman: Chinese New Year

Paul Krugman urges China to reconsider its currency policy:

Chinese New Year, Paul Krugman, Commentary, NY Times: ...China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.
Here’s how it works: Unlike the dollar, the euro or the yen, whose values fluctuate freely, China’s currency is pegged ... at about 6.8 yuan to the dollar. At this exchange rate, Chinese manufacturing has a large cost advantage over its rivals, leading to huge trade surpluses.
Under normal circumstances, the inflow of dollars from those surpluses would push up the value of China’s currency... But China’s government restricts capital inflows,... buys up dollars and parks them abroad, adding to a $2 trillion-plus hoard of foreign exchange reserves. ...
In the past, China’s accumulation of foreign reserves, many of which were invested in American bonds, was arguably doing us a favor by keeping interest rates low — although what we did with those low interest rates was mainly to inflate a housing bubble. But right now the world is awash in cheap money... Short-term interest rates are close to zero... China’s bond purchases make little or no difference.
Meanwhile, that trade surplus drains much-needed demand away from a depressed world economy. My back-of-the-envelope calculations suggest that for the next couple of years Chinese mercantilism may end up reducing U.S. employment by around 1.4 million jobs.
The Chinese refuse to acknowledge the problem. Recently Wen Jiabao, the prime minister, dismissed foreign complaints: “On one hand, you are asking for the yuan to appreciate, and on the other hand, you are taking all kinds of protectionist measures.” Indeed: other countries are taking (modest) protectionist measures precisely because China refuses to let its currency rise. And more such measures are entirely appropriate.
Or are they? I usually hear two reasons for not confronting China over its policies. Neither holds water.
First, there’s the claim that we can’t confront the Chinese because they would wreak havoc with the U.S. economy by dumping their hoard of dollars. This is all wrong, and not just because ... the Chinese would inflict large losses on themselves. The larger point is ... China has little or no financial leverage.
Again, right now the world is awash in cheap money. So if China were to start selling dollars, there’s no reason to think it would significantly raise U.S. interest rates. It would probably weaken the dollar against other currencies — but that would be good, not bad, for U.S. competitiveness and employment. ...
Second, there’s the claim that protectionism is always a bad thing... If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high..., the usual rules don’t apply.
Let me quote from a classic paper by the late Paul Samuelson...: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.
The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger.

December 26 2009

'Is Gold a Good Hedge?'

Does gold provide a good hedge against inflation and exchange rate risk?:

Is Gold a Good Hedge?, by Martin Feldstein, Commentary, NY Times: As I walked through the airport in Dubai recently, I was struck by the large number of travelers who were buying gold coins. They were ... joining the eager rush to own gold before its price rises even further. Such behavior has pushed the price of gold from $400 an ounce in 2005 to more than $1100 an ounce in December 2009.
Individual buying of gold goes far beyond ... gold coins... In addition to buying coins..., individuals are buying kilogram gold bars, exchange-traded funds that represent claims on physical gold, gold futures, and shares in gold-mining companies... And gold buyers include ... sophisticated institutions and sovereign wealth funds. ...
Many gold buyers want a hedge against the risk of inflation or possible declines in the value of the dollar or other currencies. Both are serious potential risks that are worthy of precautionary hedges. ... But is gold a good hedge against these two risks? ... The short answer is no...
Consider first the potential of gold as an inflation hedge. The price of an ounce of gold in 1980 was $400. Ten years later, the ... price of gold was still $400, having risen to $700 and then fallen back.... And by the year 2000, when the US consumer price index was more than twice its level in 1980, the price of gold had fallen to about $300 an ounce. Even when gold jumped to $800 an ounce in 2008, it had failed to keep up with the rise in consumer prices since 1980.
So gold is a poor inflation hedge. Moreover, the US government provides a very good inflation hedge in the form of Treasury Inflation Protected Securities (TIPS). ... Of course, investors who don’t want to tie up their funds in low-yielding government bonds can buy explicit inflation hedges as an overlay to their other investments.
Gold is also a poor hedge against currency fluctuations. A dollar was worth 200 yen in 1980. Twenty-five years later, the exchange rate had strengthened to 110 yen per dollar. Since gold was $400 an ounce in both years, holding gold did nothing to offset the fall in the value of the dollar. A Japanese investor who held dollar equities or real estate could instead have offset the exchange rate loss by buying yen futures. The same is true for the euro-based investor who would not have gained by holding gold but could have offset the dollar decline by buying euro futures.
In short, there are better ways than gold to hedge inflation risk and exchange-rate risk. TIPS, or their equivalent..., provide safe inflation hedges, and explicit currency futures can offset exchange-rate risks. Nevertheless,... gold ... may be a very good investment. After all, the dollar value of gold has nearly tripled since 2005. And gold is a liquid asset that provides diversification in a portfolio of stocks, bonds, and real estate.
But gold is also a high-risk and highly volatile investment. Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor .

December 23 2009

"Insecure Securities"

Hans-Werner Sinn is unhappy with the US financial system. He says "Europeans trusted a system that was untrustworthy," and that resulted in big losses for European banks:

Insecure Securities, by Hans-Werner Sinn, Commentary, Project Syndicate: ...For years, hundreds of billions of new mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) generated from them were sold to the world to compensate for the lack of savings in the United States and to finance American housing investment. Now virtually the entire market for new issues of such securities – all but 3% of the original market volume – has vanished.
To compensate for the disappearance of that market, and for the simultaneous disappearance of non-securitized bank lending to American homeowners, 95% of US mortgages today are channeled through the state institutions Fannie Mae, Freddie Mac, and Ginnie Mae. Just as there was a time when collateralized securities were safe, there was also a time when economies with so much state intervention were called socialist.
Most of these private securities were sold to oil-exporting countries and Europe, in particular Germany, Britain, the Benelux countries, Switzerland, and Ireland. China and Japan shied away from buying such paper.
As a result, European banks have suffered from massive write-offs on toxic American securities. According to the International Monetary Fund, more than 50% of the pre-crisis equity capital of Western Europe’s national banking systems, or $1.6 trillion, will have been destroyed by the end of 2010... Thus, the resource transfer from Europe to the US is similar in size to what the US has spent on the Iraq war ($750 billion) and the Afghanistan war ($300 billion) together.
Americans now claim caveat emptor : Europeans should have known how risky these securities were when they bought them. But even AAA-rated CDOs, which the US ratings agencies had called equivalent in safety to government bonds, are now only worth one-third of their nominal value. Europeans trusted a system that was untrustworthy. ...
For years, the US had a so-called “return privilege.” It earned a rate of return on its foreign assets that was nearly twice as high as the rate it paid foreigners on US assets. One hypothesis is that this reflected better choices by US investment bankers. Another is that US ratings agencies helped fool the world by giving triple-A ratings to their American clients, while aggressively downgrading foreign borrowers. This enabled US banks to profit...
Indeed, it is clear that ratings were ridiculously distorted. While a big US rating agency gave European companies, on average, only a triple-B rating in recent years, CDOs based on MBSs easily obtained triple A-ratings. ... And according to an NBER working paper by Efraim Benmelech and Jennifer Dlugosz, 70% of the CDOs received a triple-A rating even though the MBSs from which they were constructed had just a B+ rating, on average, which would have made them unmarketable. The authors therefore called the process of constructing CDOs “alchemy,” the art of turning lead into gold.
The main problem with US mortgage-based securities is that they are non-recourse. A CDO is a claim against a chain of claims that ends at US homeowners. None of the financial institutions that structure CDOs is directly liable for the repayments they promise...
Only the homeowners are liable. However, the holder of a CDO or MBS would be unable to take these homeowners to court.   And even if he succeeded, homeowners could simply return their house keys...
The problem was exacerbated by fraudulent, or at least dubious, evaluation practices. ... The US will have to reinvent its system of mortgage finance in order to escape the socialist trap into which it has fallen. A minimal reform would be to force banks to retain on their balance sheets a certain proportion of the securities that they issue. That way, they would share the pain if the securities are not serviced – and thus gain a powerful incentive to maintain tight mortgage-lending standards.
An even better solution would be to go the European way: get rid of non-recourse loans and develop a system of finance based on covered bonds, such as the German Pfandbriefe . If a Pfandbrief is not serviced, one can take the issuing bank to court. If the bank goes bankrupt, the holder of the covered bond has a direct claim against the homeowner... And if the homeowner goes bankrupt, the home can be sold to service the debt.

Since their creation in Prussia in 1769 under Frederick the Great, not a single Pfandbrief has defaulted. Unlike the financial junk pouring out of the US in recent years, covered bonds are a security that is worthy of the name.

[More on covered bonds here and here.]

December 11 2009

Rodrik: Making Room for China

Dani Rodrik says that if China wants to pursue industrial policy, as he believes it should, its membership in the WTO leaves it little choice but to keep its currency undervalued:

Making Room for China, by Dani Rodrik, Commentary, Project Syndicate: China’s undervalued currency and huge trade surplus pose great risks to the world economy. They threaten a major protectionist backlash in the United States and Europe; and they undermine the recovery in developing and emerging markets. Left unchecked, they will generate growing acrimony between China and other countries. But the solution is not nearly as simple as some pundits make it out to be.
Listen to what comes out of Washington and Brussels, or read the financial press, and you would think you were witnessing a straightforward morality play. It is in China’s own interests, these officials and commentators say, to let the renminbi appreciate. ...
This story casts China’s policymakers in the role of evil and misguided currency manipulators, who, inexplicably, choose to harm not only the rest of the world, but their own society as well. In fact, an appreciating renminbi would likely deal a serious blow to China’s growth, which essentially relies on a simple, time-tested recipe: encourage industrialization. Currency undervaluation is currently the Chinese government’s main instrument for subsidizing manufacturing and other tradable sectors...
Before it joined the World Trade Organization in 2001, China had a wider range of policy instruments for achieving this end. It could promote its industries through high tariffs, explicit subsidies, domestic content requirements on foreign firms, investment incentives, and many other forms of industrial policy. But WTO membership has made it difficult, if not impossible, to resort to these traditional forms of industrial support. ... Currency undervaluation has become a substitute. ...
The trouble with currency undervaluation is that, unlike conventional industrial policy, it spills over into the trade balance. ... Indeed, China’s current-account imbalance ... began its inexorable rise in 2001 – precisely when the country joined the WTO.
Given that WTO rules tie China’s hands on industrial policy, how much of a growth penalty would the Chinese economy suffer if the renminbi were to appreciate? My estimates, crude as they are, suggest a steep trade-off. An appreciation of 25% – roughly the extent by which the renminbi currently is undervalued – would reduce China’s growth by somewhat more than two percentage points. This is a significant effect... [I]t would be a tragedy if the most potent poverty-reduction engine the world has ever known were to experience a notable slowdown. ...
So we are left, it seems, with two equally unappetizing options. China can maintain its currency practices, but at the risk of large global macroeconomic imbalances and a major political backlash in the US and elsewhere. Or it can let its currency appreciate, at the risk of inducing a growth slowdown and political and social unrest at home. It is not clear that advocates of this option have fully comprehended its potentially severe adverse consequences.
There is, of course, a third path, but it would require re-writing the WTO’s rules. If China were allowed a free hand with industrial policies, it could promote manufactures directly while allowing the renminbi to appreciate. This way the increased demand for its industrial output would come from domestic rather than foreign consumers. It is not a pretty solution, but it is the only one. ...

One of the arguments for maintaining an undervalued currency given above is that "it would be a tragedy if the most potent poverty-reduction engine the world has ever known were to experience a notable slowdown." I don't find the poverty reduction argument very compelling. I am all for reducing poverty, but if China's policy reduces poverty within its borders at the expense of other developing countries with poverty problems that are just as bad or worse, how does that justify maintaining an undervalued currency? As Rodrik notes, China's currency policy serves to "undermine the recovery in developing and emerging markets." And it also takes jobs from those countries during normal times. Are China's poor somehow more deserving than the poor in other countries?

December 10 2009

Feldstein: The Dollar is the World's Primary "Investment Currency"

Martin Feldstein says the role of the dollar in foreign exchange reserve balances has changed:

The dollar’s fall reflects a new role for reserves, by Martin Feldstein, Commentary, Financial Times: I am often asked whether the ongoing decline of the dollar implies that it can no longer serve as a reserve currency. My short answer is that most countries no longer hold dollars and other currencies as traditional reserves. The role of foreign exchange balances has changed from being short-term funds used to bridge export-import gaps to being long-term investment funds. In this new world, the dollar has shifted from being almost the sole “reserve currency” of many countries to being the primary “investment currency”, a role that it will continue to play far into the future. 
A bit of history is helpful... In 1997 the Thai government tried to maintain the Thai bhat at an overvalued level. When it exhausted its reserves doing that, it was forced to devalue, generating substantial profits for those who had borrowed bhat and sold it for dollars. 
Speculators then attacked other Asian currencies. Even a currency not fundamentally overvalued could be profitably attacked if speculative borrowing and short-selling could force the government to exhaust its reserves and have to devalue.
These experiences taught governments two lessons. First, it is dangerous to try to maintain an overvalued currency. Second, even if its exchange rate is not overvalued, a country could face a successful attack by forex speculators if it does not have a very large amount of foreign exchange.
Countries responded by deliberately keeping their currencies undervalued to run trade surpluses and using these surpluses to accumulate foreign exchange. We now see Korea with foreign exchange assets of $200bn (€136bn, £123bn), Taiwan $300bn, Thailand $100bn and China more than $2,000bn.
These funds are no longer held to manage temporary swings in imports and exports or investment flows. They are best seen as investment funds that also deter attacks by forex speculators. Similarly, the oil-producing countries ... recognize the investment nature of their foreign exchange accumulation. Instead of just holding these balances in short-term US Treasury bills, they have created sovereign wealth funds with sophisticated investment strategies.
It is prudent for any country with large foreign exchange balances to diversify those funds. ... That diversification cuts demand for the dollar, putting pressure on its value. ... But even as countries diversify away from exclusive reliance on dollars, the dollar will continue to be the main form of liquid investment for countries around the world. 

As this portfolio rebalancing comes to an end, demand for dollars will stop falling ... What looks like a crisis of confidence in the dollar as a reserve currency is just part of the evolutionary process that will eventually halt the dollar’s decline.

Even though the exchange rate might stabilize at a lower level, over time the volatility of the exchange rate could increase. If foreign currency holdings are being held more for investment purposes and less as insurance against a speculative attack, then the composition of those balances, e.g the part held as dollars, ought to become more sensitive to changes in economic conditions, This would cause an increase in volatility within the financial sector as the demand for dollar denominated assets waxes and wanes over time.

December 04 2009

Savings Gluts and Bubbles

Robin Wells says our current problems began with a global savings glut that was caused by "thrifty Germans, and state-owned enterprises in China – along with governments of other countries, of course, turning a blind eye to the escalating problems." And, she argues, if something isn't done to eliminate the glut, then asset bubbles and instability will continue, "exacerbating income inequality and favoring wealthy bankers and the Chinese elite":

Big savers got us into this mess, as well as big spenders, by Robin Wells, Commentary, Comment is Free: The world is trapped in a global savings glut. It is both the source of our economic woes and an obstacle to the task of pulling ourselves out of the ditch. Worse yet, the glut's continued existence will feed a succession of asset bubbles until we confront it, head on, and find ways to soak up the excess.
Yes, we can blame the City and Wall Street for turning the global savings glut into fissile material. But that's like saying, "hyenas do what hyenas do". Given extraordinarily lax regulation and a flood of money to play with, bankers were just acting according to their incentive schemes. They merely took advantage of the opportunities the glut presented. The real culprits are thrifty Germans, and state-owned enterprises in China – along with governments of other countries, of course, turning a blind eye to the escalating problems.
The flood of savings in the global economy arose from Germany and China's persistent trade surpluses over the last decade. A country with such a surplus sells more to its trading partners than it buys in return. Persistent deficit countries – the US, Britain, Iceland, and the eurozone excluding Germany, France and Italy – sell assets to the surplus countries to pay for their deficits. Thus persistent surplus countries accumulate the assets of persistent deficit countries: in the case of China, US treasury bills; in the case of Germany, Spanish eurobonds, sterling notes, and US sub-prime mortgages.
What makes this a global glut is that the world as a whole is saving more than can be profitably invested. The corollary is that, eventually, those funds will earn less than nothing. And through financial engineering, those losses are now distributed around the world.
What was the cause? Germany's surpluses were a result of its attempt to export its way out of the stagnation arising from the reintegration of east and west Germany, and to support an ageing population. Its excess savings were spread among the investment hotspots of Spain, Portugal, the Baltics, Ireland, Iceland, Britain and the US.
The origins of China's persistent surpluses are more ominous. Data from China's central bank show that the steep rise in income over the last 10 years created by export-led growth largely bypassed ordinary households. In contrast, from 1997 to 2007, corporate profits as a percentage of income nearly doubled, reaching 23%. And the principal beneficiaries were the state-owned enterprises. Politically powerful, they enjoy a privileged position – with cheap government-directed credit, subsidized access to resources, and low wages without worker protections, they effectively transfer income from workers to state-owned enterprises. Unless the government spends some of its huge holdings of US Treasury bonds to help its citizens, or compels state outfits to share their profits with households, one must question whose interests within China are being served by these policies.
The short-term problem of managing the fallout from the savings glut and the longer term problem of ending it both appear devilishly hard. Because hard-hit eurozone countries can't use currency depreciation they face years of grinding asset and wage deflation. To add insult to injury, the European Central Bank's relatively tight monetary policy is better suited to Germany than to devastated deficit economies like Spain.
It is Britain's good fortune to possess a falling pound, which almost certainly will allow it to recover more quickly than troubled eurozone economies. And the UK has dealt forcefully with its crippled banks in comparison to the US. In both countries, however, deregulation of financial markets led to excessively large financial sectors, fuelled by merchandising of the savings glut, leaving them unable to confront the mounting consequent problems.
Until the savings glut is vanquished, asset bubbles and instability will be fed, exacerbating income inequality and favoring wealthy bankers and the Chinese elite. It will continue drawing resources away from productive sectors of the economy and channeling them into high-paying but socially useless financial engineering – or into yet more excess capacity.
Short of a miraculous new technology to soak up the savings glut, a global rebalancing of production and consumption will be necessary. Persistent surplus countries will need to save less and consume more; deficit countries will need to consume less and save more.
In practice Germans will need to overcome their fear of fiscal deficits and become less export-dependent. China will be a harder case. According to the European Chamber of Commerce, China is adding excess production capacity at a breakneck pace. And by keeping the yuan artificially low, it is stymieing global rebalancing. After it recently told the US and Europe to butt out of its currency affairs, western leaders may find the threat of sanctions is the only way to get the attention of China's state-industrial complex. Afflicted eurozone countries should insist on looser monetary policy and curbs that will prevent internal eurozone trade imbalances getting out of hand again.
And eventually, but not until their economies are clearly on the mend, Americans and Britons will have to get their fiscal houses in order. In the end, perhaps we will have learned from this experience just how expensive cheap credit and excessive thrift can be.

November 17 2009

"China and the American Jobs Machine"

Robert Reich says China won't be abandoning its currency policy anytime soon:

China and the American Jobs Machine, by Robert Reich, Commentary, WSJ: President Barack Obama says he wants to "rebalance" the economic relationship between China and the U.S. as part of his plan to restart the American jobs machine. "We cannot go back," he said in September, "to an era where the Chinese . . . just are selling everything to us, we're taking out a bunch of credit-card debt or home equity loans, but we're not selling anything to them." He hopes that hundreds of millions of Chinese consumers will make up for the inability of American consumers to return to debt-binge spending.
This is wishful thinking. True, the Chinese market is huge and growing fast. ... But in fact China is heading in the opposite direction of "rebalancing." Its productive capacity keeps soaring, but Chinese consumers are taking home a shrinking proportion of the total economy. Last year, personal consumption in China amounted to only 35% of the Chinese economy; 10 years ago consumption was almost 50%. Capital investment, by contrast, rose to 44% from 35% over the decade. ...
Chinese companies are plowing their rising profits back into more productive capacity—additional factories, more equipment, new technologies. China's massive $600 billion stimulus package has been directed at further enlarging China's productive capacity... So where will this productive capacity go if not to Chinese consumers? Net exports to other nations, especially the U.S. and Europe. ...
The Chinese government also wants to create more jobs in China, and it will continue to rely on exports. Each year, tens of millions of poor Chinese pour into large cities from the countryside in pursuit of better-paying work. If they don't find it, China risks riots and other upheaval. Massive disorder is one of the greatest risks facing China's governing elite. That elite would much rather create export jobs, even at the cost of subsidizing foreign buyers, than allow the yuan to rise and thereby risk job shortages at home.
To this extent, China's export policy is really a social policy, designed to maintain order. Despite the Obama administration's entreaties, China will continue to peg the yuan to the dollar... This is costly to China, of course, but for the purposes of industrial and social policy, China figures the cost is worth it. ...

While China's currency policy is certainly a worthy topic for discussion, lately we are spending a lot of time pointing our fingers at others and blaming them for our problems rather than engaging in the more difficult task of getting our own house in order. I'm not saying that we should ignore things that unfairly disadvantage us, whatever those might be, just that a continued focus on external factors provides a convenient excuse to avoid going through the difficult changes needed to reform our own economy, an excuse that can be exploited by powerful interest groups opposed to needed change (though Reich at least touches on the US side of the equation in a part I left out).

Yes, China needs to change its currency policy, and the fact that it won't or can't change will probably lead to further economic imbalances, perhaps to dangerous levels, and cause increased political tension in the future. But I hope we don't allow the financial industry and others wishing to deflect blame for the crisis and avoid stricter regulation to use the controversy over China's currency policy to divert our attention elsewhere and alter the narrative about how we got into this mess.

November 16 2009

Paul Krugman: World Out of Balance

Paul Krugman reiterates that China's currency policy must change:

World Out of Balance, by Paul Krugman, Commentary, NY Times: International travel by world leaders is mainly about making symbolic gestures. Nobody expects President Obama to come back from China with major new agreements, on economic policy or anything else.
But let’s hope that when the cameras aren’t rolling Mr. Obama and his hosts engage in some frank talk about currency policy. For the problem of international trade imbalances is about to get substantially worse. And there’s a potentially ugly confrontation looming unless China mends its ways. ...
Despite huge trade surpluses and the desire of many investors to buy into this fast-growing economy — forces that should have strengthened the renminbi, China’s currency — Chinese authorities have kept that currency persistently weak. They’ve done this mainly by trading renminbi for dollars, which they have accumulated in vast quantities.
And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.
What makes China’s currency policy especially problematic is the depressed state of the world economy. ... China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters.
But why do I say that this problem is about to get much worse? Because for the past year the true scale of the China problem has been masked by temporary factors. ...
That, at any rate, is the argument made in a new paper by Richard Baldwin and Daria Taglioni of the Graduate Institute, Geneva. As they note, trade imbalances, both China’s surplus and America’s deficit, have recently been much smaller than they were a few years ago. But, they argue, “these global imbalance improvements are mostly illusory — the transitory side effect of the greatest trade collapse the world has ever seen.”
Indeed, the 2008-9 plunge in world trade was one for the record books. What it mainly reflected was the fact that modern trade is dominated by sales of durable manufactured goods — and in the face of severe financial crisis and its attendant uncertainty, both consumers and corporations postponed purchases of anything that wasn’t needed immediately. How did this reduce the U.S. trade deficit? Imports of goods like automobiles collapsed; so did some U.S. exports; but because we came into the crisis importing much more than we exported, the net effect was a smaller trade gap.
But with the financial crisis abating, this process is going into reverse. Last week’s U.S. trade report showed a sharp increase in the trade deficit between August and September. And there will be many more reports along those lines.
So picture this: month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers. If I were the Chinese government, I’d be really worried about that prospect.
Unfortunately, the Chinese don’t seem to get it: rather than face up to the need to change their currency policy, they’ve taken to lecturing the United States, telling us to raise interest rates and curb fiscal deficits — that is, to make our unemployment problem even worse.
And I’m not sure the Obama administration gets it, either. The administration’s statements on Chinese currency policy seem pro forma, lacking any sense of urgency.
That needs to change. I don’t begrudge Mr. Obama the banquets and the photo ops; they’re part of his job. But behind the scenes he better be warning the Chinese that they’re playing a dangerous game.

November 07 2009

"Why the Renminbi has to Rise to Address Imbalances"

Martin Feldstein joins those arguing that China must let the value of the renminbi rise:

Why the renminbi has to rise to address imbalances, by Martin Feldstein, Commentary, Financial Times: Global leaders have agreed reducing global imbalances is a priority. ...[T]hat agreement means the US must raise its national saving to be less dependent on foreign funds. China must lift domestic spending to maintain high employment without producing so many exports.
Some progress is happening on both fronts. The US household savings rate has risen, driven by the need for US households to rebuild wealth. Corporate retained earnings have also begun to rise. But increasing private saving is not enough ... if federal deficits remain high. The Obama administration must agree a budget that will reduce deficits in the years ahead.
China has succeeded in raising its domestic spending through fiscal incentives and an explosive growth of credit. ... Chinese government spending has also increased domestic demand via major rises in infrastructure investment and building low income housing.
But while these two shifts are necessary to reduce global imbalances, they are not enough..., exchange rates must also adjust.
The dollar must decline relative to other currencies to make US products more attractive to foreign buyers and to cause Americans to substitute US goods and services for imports. ... That is why the recent decline in the dollar relative to the euro, the yen and other currencies is ... natural and desirable...
Unfortunately, the Chinese government has not allowed the renminbi to appreciate. ... With the dollar falling relative to other major currencies, the fixed exchange rate of the renminbi relative to the dollar has caused the Chinese currency to fall relative to the euro, yen and other currencies. The trade-weighted value of the renminbi has therefore been declining, making Chinese exports more attractive and foreign goods more expensive in China.
The result has been an increase in China’s exports from $276bn in the second quarter of the current year to $325bn in the third quarter. This helps lift GDP and jobs in China but prevents reducing global imbalances.
China’s policy of keeping the renminbi weak means that the US dollar must decline more rapidly against the euro, yen and other currencies to achieve the same overall trade-weighted fall of the dollar. China’s weak renminbi policy therefore not only prevents remedying China’s large current account surplus but also reduces Europe’s exports. ...

Although China has agreed to take steps to reduce global imbalances and its trade surplus, it is reluctant to let its currency rise. ... Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.

[Traveling: Scheduled to post at preset time.]

November 03 2009

"Death by Renminbi"

Thomas Palley says China's currency policy must change:

Death by Renminbi, by Thomas I. Palley, Commentary, Project Syndicate: Over the last several weeks, the dollar's depreciation against the euro and yen has grabbed global attention. In a normal world, the dollar's weakening would be welcome, as it would help the United States come to grips with its unsustainable trade deficit.

But, in a world where China links its currency to the dollar at an undervalued parity, the dollar's depreciation risks major global economic damage that will further complicate recovery from the current worldwide recession.

A realignment of the dollar is long overdue. Its overvaluation began with the Mexican peso crisis of 1994, and was officially enshrined by the "strong dollar" policy... That policy produced short-term consumption gains for America,... but it has inflicted major long-term damage ... and contributed to the current crisis.

The overvalued dollar caused the U.S. economy to hemorrhage spending on imports, jobs via off-shoring, and investment to countries with undervalued currencies.

In today's era of globalization, marked by flexible and mobile production networks, exchange rates affect more than exports and imports. They also affect the location of production and investment.

China has been a major beneficiary of America's strong-dollar policy, to which it wedded its own "weak renminbi" policy. As a result, China's trade surplus with the U.S. rose... The undervalued renminbi has also made China a major recipient of foreign direct investment, even leading the world in 2002 ― a staggering achievement for a developing country.

The scale of recent U.S. trade deficits was always unsustainable...
But China retains its undervalued exchange rate policy... When combined with China's rapid growth in manufacturing capacity, this pattern promises to create a new round of global imbalances.

China's policy creates adversarial currency competition with the rest of the world. ... Furthermore, the problem is not only America's. China's currency policy gives it a competitive advantage relative to other countries, allowing it to displace their exports to the U.S. ... Yet a mix of political factors has led to stunning refusal by policymakers to confront China.

On the U.S. side, a lingering Cold War mentality, combined with the presumption of U.S. economic superiority, has meant that economic issues are still deemed subservient to geo-political concerns. That explains the neglect of U.S.-China economic relations, a neglect that is now dangerous to the U.S., given its weakened economic condition.

With regard to the rest of the world, many find it easy to blame the U.S., often owing to resentment at its perceived arrogance. Moreover, there is an old mentality among Southern countries that they can do no wrong in their relationships with the North...

Finally, all countries likely have been shortsighted, imagining that silence will gain them commercial favors from China. But that silence merely allows China to exploit the community of nations.

The world economy has paid dearly for complicity with and silence about the economic policies of the last 15 years... It will pay still more if policymakers remain passive about China's destructive currency policy.

Our problems are not China's fault.

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