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

November 28, 2009

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!


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

November 4, 2009

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…..

Deficits Proj

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?