Obsessed with the trade deficit and oblivious to real economic fundamentals, George Shultz and John Taylor are happy about the falling dollar, the subprime mess, Wall Street volatility, $100-oil, and $820-gold:
Turmoil in the US's financial markets got the top billing in news reports about the recent meetings of the world's leading international policymakers in Washington. Virtually everyone expressed concern that the housing slump and the financial crisis triggered by the subprime mortgage market would significantly slow down the US economy, and perhaps the world economy. But there is a surprising silver lining. Signs of it were revealed by the absence of reporting on the big bugaboo of the past few years: the US current account deficit.
The good news is the recent reversal of the steady upward climb in the current account deficit. During the past three quarters for which we have data the deficit has been cut by $119bn, falling from about 6 per cent of gross domestic product to 5 per cent, and the adjustment appears to be continuing.
Why the reversal? One explanation is the implementation of policies that these same international policymakers agreed to at recent past meetings. The basic economic principle that led to these policies is that the US current account deficit is caused by the gap between saving and investment. Accordingly, a three-pronged strategy was called for -- reducing the US budget deficit to decrease government dissaving, raising economic growth abroad relative to the US in order to stimulate US exports and increasing the flexibility of exchange rates, especially in China, to facilitate the adjustment.
David Malpass of Bear Stearns has a much better take:
Rather than "reflecting" fundamentals, the exchange rate is itself a key fundamental. It affects capital flows, jobs, inflation, and interest rates. Currency changes harm the relationship between debtors and creditors and dominate the profitability of many companies.
John Taylor is an influential economist -- his "Taylor Rule" is often thought to be the model the Fed uses to set interest rates. He was also Treasury undersecretary in the current administration and is partly responsible for America's current weak dollar policy. It appears Taylor is now rationalizing his easy money, weak dollar policies in the face of overwhelming historical evidence that such inflationary manipulation of any currency -- let alone the world's key reserve currency and unit of account -- is very dangerous.
This morning Ambrose Evans-Pritchard of the London Daily Telegraph dropped a bomb by writing that China is considering the "nuclear option" of dumping its several hundred billion dollars worth of foreign reserves if the U.S. goes ahead with protectionist policies.
Treasury Secretary Hank Paulson, who just returned from a week of high-level meetings in China, called this idea "absurd."
Bruce Bartlett offers a good summary of why China wouldn't -- and won't -- exercise the "nuclear option" here. Quite simply, it would be against their best interest:
As economist John Maynard Keynes once explained, "Owe your banker 1,000 pounds and you are at his mercy; owe him one million pounds and the position is reversed" (Collected Writings, vol. 24, p. 258). In short, the more money we owe the Chinese, the more power we have over them. Evans-Pritchard has the whole relationship exactly backwards.
But looking more closely at the quotes in the Daily Telegraph article, an alternative reading is possible, albeit a reading that reaches the same conclusion and still mitigates against the "nuclear option" charge that Evans-Pritchard makes in his article.
He Fan of the Chinese Academy of Social Sciences said that
"China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced the their dollar holdings.
"China is unlikely to follow suit as long as the yuan's exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar,"
Instead of a "threat," He Fan's statement could also be read as a very matter of fact assertion of economic reality. If the U.S. keeps pursuing its weak-dollar policy and forces China to appreciate the yuan, the effect is to reduce the value of China's reserves. China would not want to continue holding its investments in a sinking currency. This is not some dastardly scheme, but simply basic investing. As He Fan noted, other nations have already diversified away from dollars, partly to avoid investment losses in a weakening currency.
The chief cause of all these global arguments these days is not a weak yuan but a weak dollar. The custodian of the dollar is the Fed and the U.S. Treasury. An inflationary, weak dollar has been the chief cause of the run-up in energy, commodity, and real-estate prices over the last few years. Seventy-five dollar oil and the sub-prime loan shakeout are just two of the results of the Fed holding interest rates at 1% for too long and then raising rates too slowly.
China critics should beware of their logic. The U.S. dollar has been the weakest major currency. It has depreciated massively against the euro. Using the reasoning of the China bashers, one would have to conclude that the U.S. is by far the worst currency manipulator in the world. But they have a completely erroneous economic model. Chinese exports of goods and U.S. imports of capital are driven by fundamentals -- the hyper-growth of Chinese productivity, labor supply, and manufacturing capacity on the one hand and the financial and technological sophistication of the U.S. on the other. This sophistication means profits and rates of return are far higher in the U.S. than most of the rest of the world. We therefore attract capital while developing nations export lots of countable goods.
As Don Luskin notes, we import more from Canada (mostly oil and other natural resources) than we do from China, but is Canada a currency manipulator? Other nations link their currencies to the dollar, but we do not mind it. We actually encourage it. The Chinese yuan (along with the dollar) has depreciated substantially versus the euro over the last decade, yet growth of European imports from China have grown at the exact same rate as U.S. imports from China. The exchange rate is not the issue.
Robert Mundell knows the very opposite of conventional wisdom over the trade deficit is true:
The high U.S. trade deficit, widely supposed to be unsustainable, is not only sustainable, Prof. Mundell argues, it is necessary to the functioning of the global economy.
Winner of the 1999 Nobel Prize in economics, Mundell has done the best and deepest thinking on this topic, two recent examples of which can be found in interviews in the Far Eastern Economic Review and BusinessWeek.
The Chinese have lots to answer for -- intellectual property violations, environmental degredation, and the safety of their food and manufactured exports, to name just three big concerns.
But the real "nuclear option" of self-destructive protectionism is being contemplated by our very own politicians in the Senate Banking Committee and on the presidential nomination trails.
This news proves our point of just how risky it is for someone of Ben Bernanke's deservedly high stature to get in the middle of a currency/trade debate.
Mr. Bernanke dropped ... references in the original text of his speech that called China's suppression of the yuan's value an "effective subsidy" for firms that "focus on exporting rather than producing for the domestic market." The chairman had used the word "subsidy" to describe China's currency practices three times in the written text, which was released before his appearance and posted to the Fed's Web site.
But with the specter of the mushrooming U.S.-China trade imbalance hanging over the talks, Mr. Bernanke's flirtation with the term "subsidy" took on heightened political and legal significance. Many lawmakers, manufacturers and labor unions accuse China of cheating in foreign trade -- and effectively subsidizing its exporters -- by preventing the yuan from rising further and faster. A weak yuan makes American goods and services relatively expensive, and Chinese products relatively cheap.
Chinese officials say that stability in the yuan's exchange rate provides important benefits to their economy, and that they are committed to allowing market forces to play a greater role over time. The currency has increased just 5.8% against the dollar since the Chinese authorities first allowed it to move in July 2005, and Mr. Bernanke sided with those who say its value is far below what would be set by a free market.
If it concluded that China is subsidizing exports through its currency policies, the Bush administration could well be forced to take punitive measures against China at the precise moment it is undertaking a government-wide effort to improve U.S.-Chinese economic relations. The Treasury Department, for instance, would come under intense congressional pressure to declare China a currency manipulator in its semiannual foreign-exchange report. Mr. Paulson is already two months late with the next report, which was due Oct. 15.
Furthermore, the administration might find itself obliged to bring a trade case against China for violating international rules against export subsidies.
Treasury and Fed officials denied that Treasury had brought any pressure to bear on Mr. Bernanke to modify his language. "It was a spontaneous decision to enhance the clarity of that sentence," said Fed spokeswoman Michelle Smith. The Fed is fiercely protective of its independence from political Washington.
If a weak currency can be defined as an illegal subsidy, the U.S. is indicting itself.
Delivering a major address in Beijing, Fed Chairman Ben Bernanke today jumped headlong into the dollar-yuan debate. In many ways the speech is erudite and illuminating. But on the key policy question of the day, it falls short.
Bernanke says forcefully that the RMB (yuan) needs to appreciate, or strengthen, against the dollar. In the next breath, Bernanke says the foreign exchange value of the RMB should be set by the market. But if the vast and impersonal global market should set the rate, how does Bernanke know -- and advocate -- that the RMB should strengthen? Which is it, Mr. Chairman?
Nobel economist Robert Mundell believes that depending on the two nations' monetary policies and other macro factors, the RMB is just as likely to weaken versus the dollar if we precipitously broke the dollar-RMB link. Ronald McKinnon of Stanford agrees, arguing that forex values essentially follow a random walk and only react fundamentally to monetary policy. McKinnon believes our efforts to force a large Chinese yuan appreciation will get us less than nothing -- inflation, financial instability, and not even any "improvement" in the trade gap. The U.S. has been using supposed free-market rhetoric -- "shouldn't we let markets set the rates?" -- to disguise its real goal of a weak-dollar, strong-RMB policy.
Don Luskin insightfully weighs in:
Treasury Secretary Henry Paulson cuts a deal. The New York Times reports,
Mr. Paulson asserted that as a result of the talks, China would move to open its economy and enforce intellectual property rights, and would adopt "greater flexibility" in exchange rates. The United States, he said, would strive to increase its savings rate so that it borrows less from China to feed an addiction to imports.
Translation -- US to China: do everything we want, and as your reward we'll buy less stuff from you.
Bernanke also criticizes the Chinese for letting their currency weaken 10% over the last five years. But as Luskin also points out, we have let the U.S. dollar weaken by 24% over the last five years. And because the RMB was rigidly pegged to the dollar for most of that time, the Chinese weakening was entirely our doing. Who, then, are we to talk?
Clearly, the weakish dollar (and thus weakish yuan) has given both the U.S. and Chinese economies a short-term jolt, including some inflation (with more likely to come in future CPI and PCE readings). But one more question that no one can ever answer: If the Chinese currency is so dramatically weak, why don't they have run-away inflation, far beyond what we see?
Because of its mild appreciation over the last year after the Chinese opted for a more flexible dollar-RMB link, the RMB is actually stronger than the dollar. Who's the currency manipulator now?
Don't Asian nations have nefarious motives for accumulating OUR currency? Not at all. It's simply an outgrowth of the extraordinarily widespread use of the U.S. dollar as the world's trade and reserve currency. Here's more on that phenomenon.
posted to: Telecosm Lounge
date: 12/8/06 9:30:34 AM
Here's yet another way to think about the China dollar reserve situation. Asian nations accumulate lots of dollar reserves because, simply, the dollar is the most-used currency in Asia.
Most Asian trade is invoiced in U.S. dollars. For example, 80% of Korea's imports are invoiced in U.S. dollars. It invoices 87% of its own exports in U.S. dollars. Korea's use of the
Japanese yen is surprisingly low -- just 12% of imports and 5% of exports.
Continue reading "The China-Dollar Question: III" »
Do China's dollar reserves give them huge power over the U.S.? I don't think so. Here's another post from gildertech.com, aswering that widespread worry.
posted to: Telecosm Lounge
date: 12/7/06 2:19:07 PM
I don't think China's large reserves give them much power over the U.S. The Chinese hold these Treasuries because they are safe, liquid assets. It is true China will diversify its dollar reserves, but when China sells Treasuries someone else must buy them. China would not precipitously dump Treasuries in a way that would lead to a price plummet. After all, even with diversification into euros, yen, or won, they will still hold lots of dollars. Why would they want a Treasury plunge that would cut the value of their remaining dollar reserves?
Continue reading "The China-Dollar Question: II" »
With the Paulson-Bernanke delegation heading to Beijing for the first in a series of semiannual high-level talks, the China-Dollar question is getting lots of attention. We've been discussing it over at the Gilder Telecosm Lounge -- www.gildertech.com -- and I thought I'd repost some of my thoughts contained in three items here at Disco-Tech.
posted to: Telecosm Lounge
date: 12/6/06 6:11:13 PM
Inflation, I believe, is the key variable in the economic outlook. Fed Chairman Bernanke seems to agree. Last week he gave his first big speech in four months to shake the complacency out of the bond market. He said the risks for inflation are to the upside. The problem, as Don Luskin of TrendMacro has observed, is that Bernanke is only "talking the talk, not walking the hawk."
Continue reading "The China-Dollar Question: I" »
Richard Fisher of the Dallas Federal Reserve says bad data led to Fed rate mistakes over the last five years. He says the Fed held rates too low for too long, leading to wild price swings.
"[P]oor data," Fisher says, "led to a policy action that amplified speculative activity in the housing and other markets."
Markets like oil. In August I wrote
in The Wall Street Journal
that the spike in energy prices is mostly a function of the Fed's inflationary monetary policy, which is also the key factor in swings across the global economy, from cattle prices to home values to the spike in Chinese foreign reserves.
Referring to the CPI and PCE price indeces, which constantly disappoint, Fisher says, "The point is ... we need better data." But we've already got much better data -- right in our grasp. This data streams across our Bloomberg screens and CNBC tickers every moment of every day. In real time. The data is called the price of commodities, the value of the dollar, bond yields (somewhat less useful), and most importantly, the price of gold. It's real time market data. No sampling. No revisions. No lags.
Fisher is correct the Fed created the current inflation and that we need "better data." But he doesn't mention that the simple solution is right in front of us.
The importance of assets (stocks) versus incomes (flows) in economics cannot be overstated, yet it is not well understood. Michael Milken this morning in The Wall Street Journal explains why Baby Boom retirements won't, as many believe, cause financial market instability, let alone a crash.
Baby boomer asset liquidation isn't really a financial market issue because (1) there's plenty of liquidity in the global economy; (2) as the rest of the world becomes wealthier, people outside the U.S. will own a greater percentage of global assets and they'll want to keep a share of their net worth in America; (3) liquidity will grow in both developed and developing nations as they adopt recent American financial innovations and market structures; (4) as baby boomers live longer and healthier, their new mantra will become "Who wants to retire?" and (5) most assets won't need to be sold.
Milken keenly observes that "In the future, aging workers will be healthier and will use broadband technology to live and work from anywhere at the increasing proportion of jobs that involve knowledge rather than physical labor." But for this important dynamic to occur, we've got to make sure American citizens actually have real broadband. So add retirement policy and Baby Boom financial stability to the long list of reasons why rational and far-sighted broadband and telecom rules are so important to future economic success.
Milken continues to be one of the most creative financial and economic thinkers out there. I just spent two weeks in Beijing with another of the most creative financial minds around, John Rutledge, who pioneered thinking about asset stocks versus income flows 25 years ago. Both Milken and Rutledge will be speaking at our 10th annual Gilder/Forbes Telecosm Conference in Lake Tahoe, Calif. October 4-6.
Yesterday's Wall Street Journal pre-view of Treasury Secretary Hank Paulson's China speech was encouraging. Paulson emphasized the long-term "generational" relationship that we must develop with China and emphatically rebuffed the ideas and promoters of protectionism.
at the Intl Finance Forum in "Great Epoch City"
But today's New York Times re-view of Paulson's speech is more ominous. The story is titled, "Treasury chief delivers new warning to China." It emphasizes the contentious dollar-yuan exchange rate issue, asserting that Paulson "used unusually forceful language in saying that China has kept the value of its currency artificially low relative to the dollar."
We talk about the dollar-yuan here because the success or failure of American technology and the world economy often depends on these currency and trade issues. Exchange rates may seem like arcane stuff, but when grandstanding politicians -- like Senators Lindsey Graham and Chuck Schumer -- threaten to blow up international trade, and thus our livelihoods and security, with their 27.5% tariff on China, we should all pay attention.
Continue reading "Paulson v. Paulson" »
For the last week, every newspaper and television show here has been speculating about Treasury Secretary Hank Paulson's upcoming visit to Singapore and China. What will he say, especially on the yuan-dollar exchange rate issue, every commentator wonders.
This morning we got a preview in The Wall Street Journal, and I am mildly relieved. It looks like Paulson is emphasizing free trade, protection of intellectual property rights, and the long-term strategic relationship -- and somewhat de-emphasizing the dollar-yuan issue. He still errs in pushing for a stronger yuan, but at least right now it does not seem the major focus of his visit.
Treasury Secretary Hank Paulson
Paulson instead appears to be taking a more "Asian" philosophical view. "Both in China and in the United States we must not allow ourselves to be captured by harmful political rhetoric or those who engage in demagoguery," he will say in a speech in Washington today. "Instead we must realize that the U.S.-Chinese relationship is truly generational and demands a long-term strategic economic engagement." Bingo.
Most important of all, Paulson in the Journal article explicitly scolds Sens. Lindsey Graham and Chuck Schumer for their stupendously stupid protectionist tariff legislation, which they are threatening to revive yet again.
"I would discourage...Sen. Schumer or Sen. Graham from believing that I can go and make one trip to China and bring anything back that, in and of itself, is perceived to be significant, because most things worthwhile take a longer term." He added that he would give no ground to such protectionist instincts. "You will never get me or this administration supporting protectionist legislation," Mr. Paulson said. "So I will do everything I can to talk them out of proceeding with their bill."
This Administration's view that free-floating exchange rates in general and a stronger yuan in particular would be good for either the U.S. or China is still perplexing and worrisome. A big yuan appreciation could destabilize China, and Asia, and possibly disrupt trade across the globe. This could set back important and ongoing market-based reforms here in China, exactly the opposite of the effect the Administration says it wants.
Is it too much to hope the Administration's public words are meant mostly for domestic consumption and that it won't push for a forced revaluation?
This morning Dr. Arthur Laffer continues his break with most of the other classical/supply-side economists. Dr. Laffer says inflation is nowhere in sight and the Fed is doing a "stellar" job. We can all agree with Dr. Laffer that growth does not cause inflation, the Philips Curve is (or should be) dead, and that economic growth today is stronger than most observers believe. Dr. Laffer is a national hero, who helped launch the U.S. to world economic leadership and, maybe more importantly, exported his low-tax ideas to a world in desperate need of capitalism. We are all benefiting from this global transformation that he and his mentor Robert Mundell envisioned. We continue to be somewhat flummoxed, however, over Dr. Laffer's views on monetary policy, which seem to contradict many of his earlier teachings.
Dr. Laffer's model appears to:
-- completely decouple commodity prices from Federal Reserve policy.
-- completely decouple the foreign exchange value of the dollar from Fed policy.
-- link the dollar's forex value exclusively to U.S. fiscal policy.
-- link commodity prices exclusively to economic growth and also fluctuations in the dollar "unrelated" to monetary policy.
In Dr. Laffer's model, the Fed appears to be a mostly impotent, almost meaningless entity.
-- Dr. Laffer says the dollar's strength between 1996 and 2002 resulted from the great economic policies of Presidents Clinton and Bush 43. But Bush 43's good economic policy didn't begin until the tax cut of 2003, which is when the dollar began its fall. Bush 43's great fiscal policy thus corresponds not with the strong dollar Laffer would predict but a weak dollar instead.
-- Dr. Laffer says the dollar weakening of 1985-1993 was due to the "end of the Reagan era and George Bush's and Bill Clinton's original tax increases." But the dollar weakening that began in late 1985 was a direct, concerted, and public effort of the Plaza Accord, and the weakening began before the tax reform of 1986, which was the most relevant fiscal event of that era.
-- Dr. Laffer grounds his benign inflation call almost entirely in what he sees as modest growth of the monetary base. But he does not appear to take into account rising velocity.
-- Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation.
-- IF...Growth = High Commodity Prices...AND...Growth = Strong Dollar...THEN...High Commodity Prices = Strong Dollar. But we all know this is almost never the case, and it's not the case now by a long shot.
-- For example, how do you explain the distinct periods of
> (1) the late 1990s when we had strong growth, a very strong dollar, and very low commodity prices; and
> (2) today when we have strong growth, a weak dollar, and very high commodity prices?
The difference, one can only conclude, is monetary policy. Likewise, in the early to mid-1980s, we had strong growth and a strengthening dollar. In the mid- to late 1980s, we had strong growth and a weakening dollar. The explicit difference was monetary policy.
-- Dr. Laffer then turns around and agrees with us that high commodity prices are determined partly -- or "exacerbated" in his term -- by a weak dollar. But he steadfastly denies that either has anything to do with the Fed. This after the Fed has just engaged in some four years of an explicitly "accomodative" monetary policy. Moreover, this accomodation was transmitted to China via the dollar-yuan currency link. So any extra commodity demand coming from China since 2003 has been in large part a result of a weak dollar supercharging an already fast-growing Chinese economy. And so we're right back where we started -- the Fed.
As former German banker Otmar Emminger said in 1985, the value of the dollar is "the most important price in the world economy." I don't see how we can ignore, let alone repudiate, this key theoretical tenet and practical guide.
- Bret Swanson
Yesterday, CNN broadcast yet another program about the "energy crisis" and speculated about the events that could lead to more than a crisis -- a nightmarish energy catastrophe -- in 2009. But without the faintest understanding of why oil prices are high today, all these analyses, prognostications, and alternative energy schemes are worse than useless. They are dangerous.
See my article on the crucial link between oil and monetary policy -- "The Elephant in the Barrel" -- in the Weekend Edition of The Wall Street Journal (sub. req.). Non-subscribers can go here for the full article.
This morning Daniel Yergin, the famous energy analyst and Pulitzer Prize winning author of The Prize, stumbles into the very trap I warned of several days ago. Writing in The Wall Street Journal, Yergin attributes high oil prices mostly -- or even exclusively, as far as I can tell -- to political, weather, and technology disruptions around the world, the most recent being that company in Alaska with the Bad Pipes. Yergin even displays a chart of oil prices "Climbing the Wall of Worry," with the political and weather events superimposed. Trouble is, oil prices had tripled before any of these events happened. As I described in "The Elephant in the Barrel," these relatively mild supply and demand shocks account for a relatively modest portion of the elevated oil price -- maybe $10-$15. The more fundamental cause of high oil prices -- accounting for $30+ of the rise -- is a weak dollar policy at the Federal Reserve.
- Bret Swanson
A more accurate depiction
would have Federal Reserve
Chairman Ben Bernanke
balancing the oil drum
on his index finger
Nigerian pipeline explosions, Chinese demand, Arab angst, Venezuelan volatility, peak oil, and a pugnacious Putin premium: These are the usual explanations for high petroleum prices. But our discussion of the so-called "energy crisis" has ignored the elephant in the barrel: monetary policy.
Today, high oil prices are the backdrop for Middle Eastern chaos and calls for bad energy policy. It was much the same three decades ago, during the 1970s, when high prices yielded similar violence against our fellow man and against good economics. This is no mere coincidence. A weak dollar is the key culprit, now as then.
. . .
Today, commodity prices across the board, from coffee to cattle to carbon fiber, remain near 25-year highs. High oil prices are not an exception but the rule, not a unique phenomenon driven mostly by geopolitical risk and demand but just another commodity whose price is determined primarily by the value of the dollar.
Expensive oil is not exclusively a monetary event. Risk and demand do matter. But comparing oil to other commodities, especially the key monetary guide of gold, we find that elevated risk and demand explains only $10-$15 of the higher oil price. Something around $30 of the higher price is explained by a weak, inflationary dollar. The entity most responsible for expensive oil is thus the Federal Reserve.
. . .
Continue reading "The Elephant in the Oil Barrel" »
Supply-side economists for decades have said that there is only one closed economy -- the global economy. Economic policy must therefore take into account global movements of goods, services, people, capital, and assets. Monetary policy, in particular, must acknowledge the dollar's preeminent place in the world economy and the effect the intrinsic value of the dollar and its value vis-a-vis other currencies has on world trade and politics.
Finally, a top policymaker is acknowledging this key fact enunciated by Robert Mundell and the supply-siders so long ago. Last night in New York, Fed chief Ben Bernanke said that "the central bank would need to pay more attention to global financial conditions in setting interest rates, moving beyond its usual focus on domestic economic forces," according to the New York Times. We're not sure the rest of the speech lives up to this one big key insight, but it's a start. More later....
Mike Darda asks a very good question of those who complain of Chinese currency "manipulation":
It is telling that the anti-China crowd in Congress has not taken aim at other dollar-linked or dollarized countries with destructive tariff proposals or charges of currency manipulation. Where are the tariff threats or cries of currency manipulation against Ecuador, El Salvador, East Timor, Panama, Lebanon, Hong Kong, Saudi Arabia, Kuwait, or Malaysia, all of which either use the dollar as legal tender, fix their currencies to it, or manage them in a tight band against it?
Here are Mike Darda and Steve Forbes with the two best debriefings of the Greenspan era. Both are from The Wall Street Journal where a subscription is required.
Mr. Greenspan probably made his most interesting contributions to economics in the fields of trade and productivity, where he recognized the power of the information age and helped beat back ever-present protectionist sentiment with eloquent explanations of globalization and its benefits. He surely was a savvy politician and inspired confidence on Wall Street. Yet for all his many virtues, monetary policy remains poorly understood by average Americans and even most financial and economic experts. Mr. Greenspan's opaque and shifting rationales and methodologies leave many wondering what he actually thinks and what comes next.
Although the U.S. economy has generally prospered over the last 18 years, dollar instability generated at the Fed caused the Asian crisis of the late 1990s and the crash of the American market in 2000-2002. Now inflation is peeking over the wall for the first time since Mr. Greenspan took the reigns. After, a period of price stability in the early to mid-90s, where the Fed appeared to be tracking real-time price indicators, the Fed for the last decade has regressed to a seeming reliance on backward-looking data. This has produced a pendulum effect, where the Fed is always out of phase with current market conditions, yielding a cycle in which it can't catch up fast enough but then overshoots the mark.
With Mr. Greenspan's deserved prominence and credibility, and with his seeming intuitive grasp of globalization, he could have led a new effort to stabilize monetary and trade policies around the world. Instead, specious arguments about China's monetary conduct still get a popular hearing and threaten to escalate into a trade/currency war. Iran is moving to sell its oil in euros, and others could follow. Asia is considering a future regional currency similar to the euro. Global monetary issues abound, and I'm not sure the U.S. has properly set the stage. All these matters, abroad and at home, would be far simpler if we remembered to keep the dollar as good as gold.
It looks like we might have some progress at the U.S. Treasury Department, which mostly botched the China currency-trade issue over the last few years. Now Undersecretary Tim Adams is changing the biannual monetary-trade report that previously was used, among other purposes, to label nations "currency manipulators," whatever that means. As Adams now acknowledges, the economics surrounding these currency and trade matters is much more subtle than the "on-off switch" approach that Treasury had been taking (and that Congress wished it would continue). There are no guarantees the new, more nuanced, more frequent reports will also be more intelligent, but this change points in the right direction.
UPDATE: Maybe I spoke too soon. Other articles suggest Tim Adams wants the IMF and the international community to push harder for a Chinese yuan appreciation and that the new Treasury monetary report is a means to that end. This leads one to believe Treasury hasn't changed its flawed economic view, only its political tactics.
As we approach a new year, many economic commentators are spreading fear about the flat, or even inverted, yield curve. They claim it's a sign of recession just ahead. The yield curve is a graphical depiction of interest rates on bonds of different maturities. Normally, longer-term bonds have higher yields than short-term debt instruments because of inflationary expectations and because more risk and uncertainty are to be found over longer periods of time. It's true, an inverted yield curve often is a warning sign of recession. But only when other real-time market indicators, like commodity prices, confirm it.
In the late 1990s and early 00s, the yield curve was for long stretches inverted -- higher short term rates than long term rates -- and commodity prices were at two-decade lows, and the dollar was super-strong in the foreign exchange markets, and corporate profits were flat to falling, and the real Fed Funds rate was historically very high. These indicators were unanimous in their signal that monetary policy was far too tight, indeed deflationary. The result was the stock crash of 2000-2002, the recession of 2001, record corporate defaults, and the severe technology/telecom meltdown.
Today, none of these other indicators confirm the yield curve's so-far brief inversion. Commodity prices are at two-decade highs. The real Fed Funds rate, although it has risen consistently for the past two years, is still a bit below "neutral." Corporate profits are at record highs. The dollar has been weak, though it has been met by recent weakness in the euro -- in other words, the dollar hasn't really strengthened this year; the euro has weakened this year, while the dollar did most of its weakening in 2003-04. All these important data points say long-term rates will probably move higher as the broader market figures out that the Fed is in inflationary territory even though big inflation has not yet shown up much in the backwards looking Consumer Price Index.
The greater risk of recession will come in 2007, after the Fed feels compelled to really ratchet up rates because it missed the inflationary indicators of 2004-05 and left interest rates at 1% for too long. Right now, however, 2006 is looking pretty good.
When the biggest two news items during President Bush's China trip were his bike ride and his attempt to exit a locked door, it's clear any contentious conversations happened, well, behind that locked door. This is good news, especially on China's currency, the yuan. Both the U.S. and China reiterated their basic views, without directly contradicting the other side. President Bush said in his press conference with President Hu Jintao that "We'll continue to work with China to help implement its July commitment to a flexible, market-based currency." But Yi Gang, an assistant central bank governor, said that "China would keep the yuan basically stable...." The status quo of stable exchange rates is good for now, though at some point the U.S. will have to wise up, accept this arrangement (if not endorse it), and take a stand against the masochistic Schumer-Graham tariff legislation, which seems to rear its ugly head every other month.
Although Mao Zedong's presence still superficially dominates the main public space here in Beijing--his mausoleum at one end of Tiananmen Square and his portrait guarding the Forbidden City at the other--almost everything else in China's capital city refutes Mao's life, legacy, and ideas. Once ubiquitous, gray and brown Mao jackets have now been utterly replaced by a new national garment--colorful North Face ski jackets. The other place you'll see Mao is on all the money, known as yuan or renminbi, or simply RMB. Hundred-yuan bills, 50s, 20s, 10s, ones--it's all Mao. The irony is that Mao was not, shall we say, a terrific economist. Yet for the last 27 years, China's management of its economy and this massive transformation of the largest country on earth could hardly have been better. This includes, first and foremost, the stellar management of its currency, which endured a successful high-wire act of two price systems in the 80s--one for the old state-run economy and another for the new private economy--and then, in the mid-1990s, the linking of the yuan to the dollar. Another big success for China, the U.S., and the global economy.
In his visit last month, Treasury Secretary Snow lightened up publicly just a bit on his previous calls for China to float and appreciate the yuan by up to 30 or 40 percent, though many said he was still pushing hard behind the scenes. Incoming Fed chairman Ben Bernanke, in hearings yesterday that were otherwise somewhat encouraging, reiterated his view that a flexible, market-set exchange rate (read: possible Chinese deflation and international instability) was in China's best interest. We've been critical of Snow and Bernanke's views on this topic and will be watching and commenting during President Bush's China stay.
The Wall Street Journal notes Monday that "U.S. Treasury Secretary John Snow struck a surprisingly conciliatory tone after talks with China's top economic leaders," and that his comments "seem to put to rest speculation that the administration of U.S. President George W. Bush might declare China a 'currency manipulator' in a coming report as many in Congress are demanding." This jibes with our view, expressed yesterday, that the chances of a continued high-intensity currency and trade battle have diminished.
also notes, however, that "Mr. Snow's new stance could draw increased opposition from Congress, where a number of lawmakers are threatening to impose large tariffs on Chinese imports unless Beijing lets the yuan appreciate more sharply." The Treasury and White House will now have to make forceful and convincing arguments to lawmakers who had been led too far down a protectionist path. Undersecretary Tim Adams says the U.S. will continue to hold China to its "public" promises of a currency change. But just what the Chinese have promised is unclear. Many Chinese officials say many things, but the most high-level and high-profile statement made so far by China is President Hu's endorsement on Friday of stable exchange rates.
Either way, John Snow appears to be buying the world economy a bit more time.
Has John Snow's China trip turned from expected blizzard to a light dusting instead? Secretary Snow and other U.S. Treasury officials in China are attempting to broaden their message beyond criticism of a supposedly undervalued yuan. Snow has spent the last few days urging China to modernize its financial, credit, equity, debt, and commodity markets. This is all fine advice, as far as it goes. China knows it must establish advanced financial institutions, markets, and services. It wants to do so. It is doing so. The process is already well underway, with functioning stock markets in Shanghai and Shenzhen, a new commodities market about to open in Shanghai, and rapidly developing consumer credit and mortgage markets. Of course, many interior agricultural areas are still very backwards. Snow also this week has been seeking greater market entry for U.S. financial and insurance companies. Again, this is welcome, if standard, rhetoric. If Treasury’s focus on Chinese market liberalization means less time to agitate over a yuan revaluation, so much the better.
Back in the U.S., however, an array of special interests is already calling Snow’s trip a failure
. The Schumers and unions on the left and the manufacturers on the right can see as well as anyone that China’s President Hu Jintao has committed to a stable currency policy (as I noted in yesterday’s post). They worry that Snow has shifted his message to focus on China’s domestic financial services market. The groups are intensely pressuring Treasury to label China a “currency manipulator” in its biannual report on the topic due out in early November. Sen. Schumer, who temporarily pulled his 27.5-percent across-the-board tariff legislation this summer at the personal and public request of Fed chair Alan Greenspan, says he will re-launch
his bid to tax all U.S.-China trade if China does not revalue the yuan.
Treasury’s shift in focus this week is welcome, but its earlier intense pressure for yuan revaluation fanned the flames of protectionist sentiment and legislation. Treasury either really did agree with the protectionists, or it egged them on for far too long. Maybe it was an ultra-clever negotiating position to bring back from China this week lucrative deals for U.S. firms. The strategy might partially work. But Treasury has still boxed itself in. The protectionists have gained far more support in Congress than anybody thought they could. In a surprising test vote this spring, the Senate gave more than 60 votes to Schumer’s tariff. Even Schumer was stunned, thinking initially his bill was just a sop to New York manufacturers. So Treasury’s indulgence of protectionist economic policy – whether a mistake or an overly clever ploy – has let popular myths fester and given hope to protectionists everywhere.
It now has three choices: (1) Capitulate to the protectionist lobby, and push forward with a weak-dollar/strong yuan currency policy, backed by threat of dangerous tariffs. (2) With cleverness and finesse, pacify the protectionists while doing as little harm as possible to the Pacific economic fabric known as the U.S.-China relationship. (3) With great courage, clear economic thinking, and pro-active communication, rebuff U.S. protectionists and stand up for free trade, capitalism, a growing China, and a prospering U.S. Number 1 appears a bit less likely today than it did a week ago. Number 2 will be tempting for all politicians, but Number 3 is important for the economy and for long-term global relations. A clear statement of currency stability and free trade will reduce monetary uncertainty, negate any chance of a trade war, and send a message to financial markets and to entrepreneurs that China and America are open for business.
U.S. Treasury Secretary John Snow is in China for a nine day visit. But which nation's leader is offering supply-side economic advice? If you guessed Chinese President Hu Jintao, you are correct. Citing evanescent "imbalances," Snow continues his calls for de-linkage of the yuan from the dollar and subtly still pushes for a major yuan appreciation. The U.S. thus inexplicably continues its weak dollar currency policy. Hu, on the other hand, believes that "All countries, major economies in particular, should keep major currencies reasonably stable and prevent trade protectionism." Bingo.
Over the past decade, the dollar-yuan link has been a key source of growth and stability not only for the U.S. and China but also across the global economy. China's trade policies have not always matched Hu's positive free trade rhetoric, but at least they have made their stance clear and can now be called to account. The U.S., however, damages its own free trade credibility when it muddies the waters with monetary protectionism and tariff threats. China is not likely to substantially revalue the yuan for a number of both internal and external reasons: an overly strong yuan would hurt not just the overall Chinese economy but especially its rural farmers in the country's interior, where Beijing is focused on improving incomes relative to the coast. Deflation would reduce commodity prices and thus farm income, exacerbating income differences with the fast-growing coastal free zones.
Money is a store of wealth, a standard of value, and a unit of account. Change its value, and you change every relationship across the economy. In the short run some will win and some will lose. But in the medium and long term, everybody loses. The value of money should not fluctuate freely at every arbitrary geographic border. In an economy, money and law should be stable. Everything else should be dynamic.
With a few days left in his Asian trip, hopefully Secretary Snow will second Mr. Hu's call for stable money and free trade.
This week the Bank of China clarified the world's understanding of its new monetary regime. Its small 2-percent revaluation of the yuan vis-a-vis the U.S. dollar, the BoC said, "does not in the least imply an initial move which warrants further actions in the future." Bottom line: we should not expect significant changes in the value of the yuan. This confirms my view that China is shrewdly dousing a political tinderbox, not fundamentally altering its successful sound money principles and policies.
Our friend John Rutledge, who was initially worried about China's move, now believes 1999 economics Nobelist Robert Mundell may be closely advising the Chinese, and Rutledge is relieved.
I agree there are lots of reasons to believe Mundell is working closely behind the scenes. Mundell has offered an unusually large number of public comments on the yuan-dollar question over the last few years, and last autumn China established the Robert Mundell University for International Entrepreneurship in the Zhongguancun science and technology zone of Beijing.
If only American policymakers would listen as closely to Professor Mundell.
John Rutledge, a key economist in the early Reagan administration and since a super smart watcher of financial markets, doesn't like China's currency change. He and I agree that China's U.S. dollar peg has been a boon for both nations over the last decade. (I first wrote about the Chinese monetary issue and urged them to retain the dollar link after visiting China two years ago.) Our mild disagreement now hinges on politics. Were American politicians smarter about economics, and were our own Treasury Department not agitating for a Chinese currency change, I would be perfectly happy for China to continue its dollar peg. The idea that floating and flexible exchange rates are somehow "free market economics" is wrong. The floating currencies themselves are not governed by the market but are managed and manipulated by small groups of fallible humans known as central bankers. In my view, China's move was smart chiefly as a political matter, serving to let the air out of the bulging protectionist balloon without fundamentally changing its "strong and stable" monetary policy. If China's unhinging from the dollar truly leads to the "floating and flexible" monetary relationship U.S. policy makers say they want, along with a substantial revaluation of the yuan, I would join Rutledge in lamenting China's action. My judgment that this is a positive move on net stems from China's brilliant monetary management of the last decade and overall economic strategy of the last 27 years.
China today dealt a blow to the protectionist sentiments building in the the U.S. Congress and thus did a great favor to the global economy, especially American technology companies. China slightly changed it currency's (the yuan) value against the U.S. dollar, from 8.3/US$ to 8.1/US$. The move is immaterial economically but allows China to claim it has "revalued." The large revaluation so many U.S. politicians were seeking, but did not get, would have been bad for both China and the U.S.
China has fixed the yuan to the dollar since 1994, a brilliant move by then-economic minister Zhu Rongji. The peg created a single economic fabric stretching across the Pacific, kept China from catching the Asian flu of 1997-98, helped mitigate some of the Federal Reserve's errors, and led to the deep integration of the American and Chinese economies that we both now enjoy. It was exactly the opposite of currency "manipulation" as so many have charged.
China today also said it would drop the dollar peg in favor of a new link to a basket of international currencies. It thus retains the "fixed" nature of its international monetary relationships, a key pillar of China's economic success over the last dozen years, with the added advantage of smoothing away some of the dollar's volatility.
The largest effect is to defuse the Schumer-Graham tariff bomb aimed straight at the heart of the U.S. economy.