More on the Need for a Revaluation of the Chinese Currency

A Japanese  economist/friend of mine just returned from China.  He broached the subject of a currency revaluation to academics and government officials and received no acknowledgement of any problem with the current peg to the dollar. He recommended that I read Martin Wolf’s 12/8  column in the Financial Times.

Below  are a few excerpts from Mr. Wolf’s article, but we recommend a reading of the entire article .

Commenting on the recent speech by the Chinese premier, Mr. Wolf writes:

“Naturally, the Chinese resent the pressure. At the conclusion of a European Union-China summit in Nanjing last week, Wen Jiabao, the Chinese premier, complained about demands for Beijing to allow its  currency to appreciate.   He  protested that “some countries on the one hand want the renminbi to appreciate, but on the other hand engage in brazen trade protectionism against China. This is unfair. Their measures are a restriction on China’s development.” The premier also repeated the traditional mantra: “We will maintain the stability of the renminbi at a reasonable and balanced level.”

“We can make four obvious replies to Mr Wen. First, whatever the Chinese may feel, the degree of protectionism directed at their exports has been astonishingly small, given the depth of the recession. Second, the policy of keeping the exchange rate down is equivalent to an export subsidy and tariff, at a uniform rate – in other words, to protectionism. Third, having accumulated $2,273bn in foreign currency reserves by September, China has kept its exchange rate down, to a degree unmatched in world economic history. Finally, China has, as a result, distorted its own economy and that of the rest of the world. Its real exchange rate is, for example, no higher than in early 1998 and has depreciated by 12 per cent over the past seven months, even though China has the world’s fastest growing economy and largest current account surplus.”

…………“China’s exchange rate regime and structural policies are, indeed, of concern to the world. So, too, are the policies of other significant powers. What would happen if the deficit countries did slash spending relative to incomes while their trading partners were determined to sustain their own excess of output over incomes and export the difference? Answer: a depression. What would happen if deficit countries sustained domestic demand with massive and open-ended fiscal deficits? Answer: a wave of fiscal crises. “

“Neither answer is acceptable; we need co-operative adjustment. Without it, protectionism in deficit countries is inevitable. We are watching a slow-motion train wreck. We must stop it.”

I agree.  China’s trading partners need to become much more aggressive in pushing the Chinese on this.

Needed Now: A Costless Stimulation Package…….A Chinese Revaluation (11/28/09)

On November 16, the eve of President Obama’s recent trip to China, two very interesting op-ed pieces appeared in the New York Times.  One, The Great Wallop, was by Niall Ferguson, an economic and financial historian and Professor at Harvard.  The other, World Out of Balance, was by Paul Krugman, a Nobel Prize-winning economist specializing in international economics and finance.

The subject of the two pieces was the same and one this blog has addressed several times: China’s economic relationship to the United States, and the unsustainability of the decade old disequilibrium caused by the pegging of the grossly undervalued Chinese renminbi  to the dollar.

As Ferguson points out, this currency peg has enabled the immensely rapid, export-financed development of China, while also financing overconsumption by the U.S.  In each year from 2000 to 2008 the U.S. outspent its income, running up large trade deficits, in particular with China, and facilitating a quadrupling of China’s GDP over the same period. A truly extraordinary economic symbiosis resulting in a major economic and financial imbalance.

Ferguson dubs this symbiosis “Chimerica” and says, “In essence Chimerica constituted a credit line from the People’s Republic to the U.S. that allowed Americans to save nothing and bet the house on…well, the house.”

True, China did let their currency rise relative to the dollar in small increments from 2005 to 2008, but has maintained the peg at 6.83 renminbi to the dollar since the financial crisis worsened in 2008.  In recent months, as the dollar has declined, this peg has caused the renminbi to become more undervalued relative to other major currencies such as the euro and the yen, thus aggravating the trade positions of many other nations relative to China.

With the onset of the Great Recession, world trade collapsed and China’s exports declined coincident with the decline in the U.S. demand for manufactured goods. For a while, then, the disequilibrium lessened in intensity.  Now, however, with some recovery in demand, we could find ourselves right back where we were.

To quote Paul Krugman: “So picture this: month after month of headlines juxtapositioning 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”.

Krugman goes on to say that the Chinese evidently don’t get it. Instead of considering a change in their currency policy, they tell the U.S. to raise interest rates a curb fiscal deficits, in other words, make our unemployment problem worse. He worries that the Obama administration may not get it either, judging from the absence of any urgency in statements about currency policy.

Why is this so important right now? As Ferguson points out, there are three reasons why it is in our best interest that Chimerica comes to an end:

First, and most obvious is that adjusting the exchange rate between the two currencies would help reorient the U.S. economy by making American exports more competitive in China, the world’s fastest growing big market.

Second, by increasing Chinese demand for U.S. goods it would lessen “the potentially dangerous reliance of American economic policy on measures to stimulate domestic purchasing.  American fiscal policy is clearly on an unsustainable path, and the Federal Reserve’s negligible interest rates and the printing of dollars are artificially inflating equity prices.”

Third, revaluation of the remninbi would reduce the risk of growing international friction over trade. As pointed out above, as the dollar declines relative to other currencies, so does the renminbi which is pegged to the dollar.  Already there are stirrings about defensive counter measures on the part of other trading nations.

While it may appear difficult at first to see what China would gain from a revaluation, history has consistently shown that exporting nations can live and prosper with rising currency values as long as their productivity gains are strong.  China fits that mold.

Unhampered global free trade as been, as Ferguson points out, the very foundation of China’s economic success.  A perpetuation of the currency distortion puts that foundation at risk.

Until now, all we’ve heard from China are some mutterings about switching from the dollar peg to some form of exchange-rate management and replacing the dollar as the primary reserve currency.

As far as we can tell, unless there were unreported closed-door meetings, Obama’s visit made no progress on this important subject.

In the meantime, the administration and the congress, in a fret about unemployment, are agitating about a new supplemental stimulus package. A Chinese revaluation would be a genuine, costless stimulation package.

I hope they all understand that!

Federal Deficits….Where Will the Money Come From? (posted 11/4/09)

A dozen or so years ago I heard Pete Peterson, former Secretary of Commerce and Senior Chairman of Blackstone Group, expound on the low savings, high balance of payments deficits, and frightening outlook for the fiscal affairs of the United States. He went on to found the Peter G. Peterson Foundation with $1 billion of the proceeds of his interest in Blackstone.  The Foundation has the mission of raising the awareness of the necessity of fiscal responsibility.

At the time Peterson struck me as an alarmist.  But no more.

Over the 15 years leading up to the current economic/financial problems, our high consumption economy, combined with a significantly undervalued Chinese currency and high oil prices, caused an immense explosion of foreign-owned U.S dollar assets…….negative saving here, by both consumers and government, and high savings abroad.  Our deficits were financed in significant part by foreigners, notably China.

The long-term hope during this period was that we would see a reduced level of military spending, lower oil imports, and enough upward adjustment in the Chinese currency to start bringing things back into balance.

But China has made only token moves to revalue their currency, we have not made any meaningful progress in reducing oil imports, due primarily to price increases, and our federal deficits have exploded upward as the economy and financial system ran into serious trouble. So even as consumer savings began to rise, dissaving by government has increased rapidly. Remember that it’s aggregate savings that interest us, that is, savings of both the private and government sectors.

You’ve probably seen the numbers. Looking forward, federal deficits seem out of control.  When realistc assumptions about economic growth are plugged into the calculations, the annual and cumulative deficits are truly staggering.  And when Medicare and Social Security obligations are added, the numbers look impossible to manage. Something will have to give…..

Where does the money come from to finance these deficits? Will they have to be monetized, with treacherous implications for inflation? If so, to what extent?

These are very key questions.  As to monetization, one is tempted to say that unless the Federal Reserve’s independence is compromised, it won’t happen.  But there are several congressional camels trying to get their noses under the tent here.  As now structured, I believe the Fed could avoid significant monetizing as long as the economy is growing and unemployment is not a serious problem. If the economy is not growing satisfactorily, and unemployment is uncomfortably high, some monetization might actually be desirable, but in any event the political pressures on the Fed to keep rates low would be immense.

Above all, beware of threats to the independence of the Fed. As I have pointed out in earlier Musings, hyperinflation has never occurred in a country with an independent central bank. Or saying it differently, as Niall Ferguson did in his recent book, The Ascent of Money, inflation is always a monetary phenomenon, but hyperinflation is always a political decision.

As to funding Medicare and Social Security entitlements, at this point in time I must say the problem looks almost too big to solve. Social Security and Medicare have promised $43 trillion more in benefits to senior and disabled workers than the programs will be able to pay.  And that’s before any changes that might be wrought by the new healthcare legislation. The 2008 annual report of the trustees of the Social Security and Medicare trust funds concludes that both programs will require progressively larger transfers from general revenues to maintain projected levels of spending.

Medicare is the greater challenge. It seems very unlikely that our legislators will raise premiums sufficiently to cover the rising costs.  If not, then benefits must be significantly reduced (also unlikely) or tax revenues must be increased.  The latter looks like a shoo-in. One reputable estimate is that if financed by payroll tax, the Medicare tax would have to double to 5.7% by 2020 and triple to over 9% by 2030

Social Security will have positive cash inflow in until 2017 when it goes negative.  But starting next year, 2010, the $80 billion or so of surplus Social Security annual cash inflow that has been borrowed  by congress and used for other purposes begins to shrink and will have to be found elsewhere., thus further aggravating the task of finding financing for the federal deficit. By 2020 today’s $80 billion surplus will become a $75 billion shortfall.  The shift of $155 billion will have to come from either general revenue or from a big jump in the payroll tax.

Meanwhile, back to the projected total deficit where we revert to talking about trillions of dollars instead of mere billions.  No matter how you slice it, the federal government must find $12 to $15 trillion in cash over the next 10 years.  From where?  How?

If, for a variety of reasons, including lower net exports to the U.S., fear of a weak dollar, fear of U.S. inflation, and reluctance to add to already large dollar holdings, foreigners do not buy large hunks of dollar assets, including new federal debt, the money must come from either domestic savings or new money creation.

If domestic private savings are to be the primary source of funding, significantly higher interest rates will be required to attract those savings (which would also help to keep foreigners from abandoning us).  If higher interest rates are deemed undesirable as a matter of economic policy, then higher taxes seem to be the only answer.  But, of course, both high interest rates and higher taxes stunt economic growth, so we are looking at a vicious circle.

Hmmmmmm……  higher interest rates, higher taxes, higher domestic private savings…………not exactly a formula for a high growth economy is it? Is there a way out?

The ideal, of course, would be to have a high growth, low inflation, high savings economy, with a favorable trade balance and strong dollar.  I don’t think that is a reasonable probability.  Do you?

A Sense of Unease as the Cycle Begins a Laborious Turn (posted 10/24/09)

 

Most economists now seems fairly confident that an economic recovery of global dimensions is taking place.  Indeed, much of the domestic data we follow has stopped declining and there are many series which have turned up at least slightly. The most notable exceptions are employment, which continues to decline, commercial real estate, and state and local government expenditures. As we are told by the optimists, employment is a lagging indicator, but as it continues to deteriorate it can be a heavy burden for any recovery to carry.

 The effects of cost cutting on operating leverage are showing up in better-then-expected earnings for dozens of major companies, lending credence to expectations of a quick return to past peak earnings when volume growth resumes. The question is when and how does volume growth begin.

 Mind you, there is still plenty of room for recovery just to get back to where we were in real GDP, industrial production, and profits.  At its worst, industrial production registered a 14.7% year-to-year decline, the steepest of the Post-War period.  It has now recovered a very slight 2.5% from its low point.  Capacity utilization, having dropped to the lowest point since the data started to be recorded, has risen only slightly off the bottom.

 States and municipalities (which employ more people than manufacturing) are in agony over declining revenues and increased demands for services. It’s only because of federal stimulus money going to the rescue that major disruptions in services have been avoided.  Higher taxes seem out of the question politically, but look as if they ultimately cannot be postponed.

 As we look for a slow recovery for the U.S. economy we must keep reminding ourselves that it’s a global economy we live in, and generally speaking it’s the developing part of the globe that is the best growth engine at the moment.

 Financial markets have become increasingly sure about a global recovery and its effects on corporate profits. But as I watch the optimism grow, and even as I accept the turn of the cycle, I have an unease, a sense that all is not right.

 I certainly share that view that with consumers deleveraging at a considerable speed, with unemployment still rising, bank credit still contracting, and capacity utilization very low, the recovery will lack vigor. But that’s not the reason for my unease.

The financial world has not been reformed.  Far from it.  The “too big to fail” firms have only become bigger as a result of governments’ moves to save them. Bernanke and the president himself have asked for an end to “too big to fail”. Just how we do that is quite unclear.  I am becoming convinced that any reform legislation should require that these financial giants be broken up into smaller pieces to restore the kind of healthy competition that any industry should have. If that’s not going to happen, then we need very strong oversight and regulation of the survivors. We can’t let them return to playing the same games that finally sent them to the taxpayer trough.

 When I read a Wall Street Journal headline that investment banks expect to pay record bonuses, I get mad.  Has nothing changed?  These firms are remarkably politically insensitive to flaunt their record profits in the faces of taxpayers and the body politic, seemingly thumbing their noses at the rest of us, including the millions who are unemployed because of the excesses created by these very same firms? Goldman Sachs may have paid back all the taxpayer money, but they might not even exist had not the federal government injected sufficient cash into AIG to allow that company to make good on its portfolio of credit default swaps.

 So far I see nothing in the way of seriously proposed reforms that is likely to produce real change in behavior. Naked short selling continues, and bear raids on a company’s stock, which brought many firms to their knees last year, are still possible. The uptick rule, which we lived with for more than 70 years should be reinstated. (This rule required any short sale to be executed only on a price uptick from the previous sale.)

 Global financial markets need a watchdog to oversee systemic risk, to identify it early and then prevent it from developing.  The IMF would seem to be a likely candidate, but we’re a long way from any program with real teeth. The capital structures of financial firms must be firmly regulated. Leverage and asset quality need strong oversight.

As a starter, we need a domestic overseer of systemic risk, but we seem to be mired in a turf battle that is slowing progress on this to a crawl.  The longer we tarry past last winter’s point of maximum stress the less likely we will see an effective agency put in place.

 In an earlier Musing I asked this question: If prolonged periods of stability sow seeds of their own destruction, what kind of seeds do periods of instability create?

 Over the past 60 years the U.S. has experienced 10 recessions.  As we navigated these periods successfully, that is, without ultra severe consequences or systemic collapse, business and financial markets became increasingly confident that depressions were both structurally unlikely and preventable by appropriate fiscal and monetary policy.  We also saw in the early 1980’s that monetary policy could successfully be used to kill inflation.  Each time an economic problem was overcome, confidence rose another notch, culminating in willingness on the part of financial institutions, businesses, investors and consumers to assume greater and greater risks.  Financial leverage at all levels finally exploded upward.

 So the answer to my question is that past periods of instability, as they were overcome, sewed the seeds of higher confidence in stability!

 Now, in this crisis we have seen government actions in dimensions far greater than anything in the past.  I wrote here last December that I thought the Federal Reserve had taken the possibility of a depression off the table. I think that has been proved correct. But what price are we paying? 

 The immense increase in federal debt gets the most attention. To be sure, the fiscal realities facing the OECD economies are daunting.  The future almost assuredly must include some combination of substantially higher taxes, higher interest rates, higher levels of private saving, and curbs on government spending on entitlements. A potent list of growth dampeners, to be sure.

 But additionally, have we created a dangerous faith in our ability to prevent depressions?  Does the fact that we have avoided a depression cause confidence to rise again?  Are we going right back to the same games that got us in this mess?                                                                                                     

 Looking at the remarkable comeback of the stock market one might think so. And given the spineless moves toward re-regulation and prevention of systemic excesses one has a legitimate right to worry.

Low Quality Recovery; Job Losses Continue

 

As I have previously written, the so-called reccovery may be statistically a fact, but it is what I have termed very low quality.  It is the result of an end to the major negative contributors to GDP, but not actual improvement. Headwinds are still strong, and investors should be very cautious after the dramatic improvement in stock prices.

The monthly jobs report, issued last Friday, was disheartening.  Below I have quoted the analysis of the report by Dave Rosenberg, former chief economis t of Merrill Lynch, now with the Toronto-based firm of Gluskin Sheff.

“Nonfarm payrolls in the U.S. slid 263,000 in September, but the details were even more sombre. The Household Survey showed a massive 785,000 plunge in September, and employment on this score has now slid by 1.2 million in the past two months. Sustainability is the key and there can be no durable recovery without net job creation and organic wage growth, which were both lacking in Friday’s report. In fact, the combination of the workweek edging back down to retest the all-time low of 33.0 hours and the near-stagnation in hourly wages dragged the proxy for personal income down 0.2% Month-over-Month (in nominal terms) and the Year-over-Year trend is getting perilously close to deflation terrain, at +0.7% from +0.8% in August and +1.2% in July.

Civilian employment is down 4.3% Year-over-Year and that too is a record in the post-WWII era; remember, the Household survey leads the cycle and typically bottoms and peaks before the Payroll survey does. This survey showed a 785,000 plunge in employment in September, and never before has a recession ended with civilian employment declining this much (on average, it goes down around 70,000 or almost negligible the month the recession ends).

In the last three months, the Household survey shows that civilian employment has plunged 1.33 million. At the time of the end of the 2001 recession, the three-month rally was -3,000 – we hadn’t even entered the jobless recovery at that point. There has never been a time, ever, when a recession ended during a span when the economy lost 1.33 million jobs. So all the calls that the recession is over may have been a tad premature. If the jobs data are correct, and the recession is in fact not over, this entire 60% rally is at risk of unravelling.

There were absolutely no redeeming features in the data. The private nonfarm diffusion index sank to 31.9 in September from 34.9 in August (the manufacturing diffusion index fell to 22.9 from 28.3 in August) which means that for every company adding to their staff loads, more than two are cutting back. The labour force contracted by 571,000 and has plunged now by 1.1 million since May. That again is a sign of the labour market seizing up, which is very disturbing when you consider all the government efforts to stem the tide last quarter – from housing subsidies, to cash-for-clunkers, to mortgage modifications.

The fact that initial jobless claims have peaked and rolled over – modestly by historical standards – tells only half the story which is firings. It is so painfully obvious from the data what is lacking most, is new hiring, especially in the small business sector which accounts for half of the job creation in the United States. The average duration of unemployment rose to 26.2 weeks – a half year! – from 24.9 weeks in August; the median spiked to 17.3 weeks from 15.4. It is so difficult now to find a job that a record 36% of the ranks of those unemployed have been searching with futility now for at least six months. In “normal” recessions since 1950, this ratio peaked at just over 20%. It is nearly double that today. In number terms, we are talking about 5.4 million Americans who have been out of work – but looking – for at least six months. This is troubling.

The U6 measure of the unemployment rate, which is the most inclusive definition of the labour force and takes into account the fact that we have a record 9 million people working part-time because they have been pushed off full-time payrolls, hit a new high of 17.0% in September from 16.8% in August. The gap between this rate and the ‘official’ rate of 9.8% is at a record of seven percentage points. The historical norm is closer to four percentage points and so the concept of mean reversion – Bob Farrell’s first market rule to remember – suggests that the unemployment rate is going to be setting new highs for the post-WWII era before too long (the prior high was 10.8% in November-December of 1982). So the chances that we see a 13% peak unemployment rate this cycle is far from a ludicrous proposition at this point; and just in time for the mid-term elections.

The index of aggregate hours worked, which combines hours worked with the number of bodies at work, seemed to be carving out a bottom in July and August; however, it was a false bottom because this critical ingredient into GDP fell 0.5% in September, to stand at its lowest level in six years. For Q3, aggregate hours worked actually contracted at a 3.0% annual rate, so basically, what is keeping the economy afloat is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery — labour input at some point is going to have to kick in. For Q3, aggregate hours worked actually contracted at a 3% annual rate so basically, what is keeping the economy afloat, is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery; labour input at some point is going to have to kick in.

Take note that the Bureau of Labor Statistics (BLS) also announced a preliminary estimate regarding the benchmark revisions that get published every February and they suggest an additional 824,000 jobs were lost in the year to March 2009, which would put the cumulative decline at over 8.0 million (versus 7.2 million currently, which, even in percent terms – down 5.2%, is the worst in 64 years).

Many of these jobs are never coming back, either. The share of the unemployed who are not on layoff is at record 54.3% as of September. In prior recessions, this ratio would barely pierce the 40% mark. In number terms, we are talking about 8.5 million Americans who have lost their job due to permanent shutdowns, a figure that is double what you typically see at the peak of the recession. “