Brad Setser

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Will US (and Chinese) economic policy pass the Korean test?

by Brad Setser
February 18, 2005

Korea thinks China should get rid of its peg.

And the governor of Korea’s central bank, Mr. Park, thinks the US should take steps to reign in domestic US demand and reduce its twin deficits.

Park also called on the US to adopt policies to lower domestic

demand and raise private savings levels in order to reduce the country’s budget and current account deficits.This, he said: “Should be followed by global exchange rate adjustment and cooperation in economic policy. The dollar needs to weaken gradually within a range of values that is sustainable for East Asian countries.”

He also had a stark warning for the US, saying that Asian central banks may become reluctant to help the US finance its deficits.

“A steep downtrend in the dollar would make East Asian countries reluctant to buy more dollar assets, which would make it difficult for the United States to finance its deficits,” he said.

The fact that Korea is adding its voice to those calling for China to adjust its peg is significant — if for no other reason than in suggests that Korea does not like its current set of choices.

In the fourth quarter, Korea’s reserves grew by $25 billion ($100 b annualized), an absolutely unsustainable pace. Korea understands the value of reserves: Korea’s 1997 crisis stemmed in large part from a gap between short-term foreign currency debt and liquid foreign currency reserves. But there is a limit to the size of the war chest any country needs for self defense. $200 billion seems to be quite enough.

On the other hand, Korea also worries that if it does not intervene and the won rises further, its own economy will be squeezed by China.

Korea’s preferred solution: a renminbi revaluation, and less reserve accumulation throughout East Asia. That, though, could well put pressure on the US.

The plot thickens.

I suspect the Bank of England’s Mervyn King is right: the time has come for the G-7 to sit down with the large Asian economies and have a serious discussion about the current international monetary order.

King throws out one interesting fact. For most of the post war period, Asian reserves were about equal to G-7 reserves. Today, Japan and other Asian economies hold about ten times the reserves of the rest of G-7 (the US, Canada and the key European economies). This should not surprise any one, but it is still a reminder that Asian reserve accumulation on the current scale is something that is quite new – and not an intrinsic element of the Asian development model.


  • Posted by IJ

    Exchange rates is a key concern for the global economy. The EU, for example, is suffering badly.

    But what to do? The Governor of the Bank of England says in the speech that the G-7 arose out of an earlier episode of concern about exchange rate movements in the 1980s. The IMF wasn’t fulfilling its role then either.

    “I believe that we need to rethink the role of the IMF in the international monetary system. I encourage the Fund to articulate a positive vision for the management of the international monetary system in its forthcoming strategic review.”

    Rethinking the role of the IMF is surely urgent, and best done at a forum other than the IMF.

  • Posted by anne

    This is an important argument. I agree, but but but with a provision. Economists need to explain to Japan why a change in the mix of monetary and fiscal policy can speed economic growth even as the Yen strengthens in dramatic fashion.

  • Posted by IJ

    The Governor of the B of E has a point. “What is a matter for public discussion. . . is the mix of exchange rate regimes we see in the world today, and the consequences for international monetary stability”.

    Indeed, what we have at present is a system that is hurting many, especially Europe. Some countries have floating rates, but increasing numbers have fixed rates (linked to dollar monetary policy, or to euro monetary policy).

    Important background mentioned by Brad:
    “For most of the post-war period, the quantity of central bank reserves held by Asian central banks was of the same order of magnitude as the reserves held by the G-7. Over the past 15 years, both Japan and non-Japan Asia have rapidly increased their reserves, which are now nearly ten times as large as the combined reserves of the rest of the G-7. ”

    Sterling must be suffering badly under the existing arrangements. Mervyn King felt compelled to add: “do we still need a reserve currency as a source of global liquidity?”

  • Posted by anne

    What has apparently happened? Well, the Japanese stock market began what may be the steepest longest lasting decline for a developed nation in the century. The Index was 38,900 in December 1989 and about 11,500 now. Dividends are insignificant. Japanese growth faltered from 1993 and falters still.

    Then there is China. China began a development period that reminds me of the period in America after the Civil War. Developmet for what is now 1.3 billion people.

    Japanese leadership emphasizes exports above all else. Chinese leadership evidently thinks they have managed what development economists had hope for a century but in a novel way. How do you get compromise not masking of intent from Japan and China?

  • Posted by Movie Guy

    “He also had a stark warning for the US, saying that Asian central banks may become reluctant to help the US finance its deficits.”

    Ok. Shot fired. Can he or the Asian central banks back it up? If so, will they? If not, then it’s just more talk.

    As a humorous aside, imagine what he might have said had the two Koreas already reunified. 🙂

  • Posted by anne

    Suppose China allows the Yuan to rise in value. What happens to other Asian currencies? What would happen in Hong Kong? The Hong Kong dollar is pegged to our dollar, but there is no reason to believe the Hong Kong dollar would be allowed to rise in value. What about Korea and Singapore? I can argue either way.

  • Posted by anne

    The guess is that at least Australia’s Dollar would also appreciate against our dollar.

  • Posted by MTC

    anne –

    You know far more about these matters than I…but I must disagree with the statement “Japanese leadership emphasizes exports above all else.” I can think of only two Japanese leaders for whom this statement would be true: METI Minister Shoichi Nakagawa and Communications & General Affairs Minister Taro Aso. The old saw “where you stand depends on where you sit” holds true for these two gentlemen—their economic views seem to reflect the interests of the constituencies regulated and nurtured by their respective ministries. Most other Japanese leaders, including the presidents of Japan’s multinationals, agree that pushing exports is a stopgap solution that only obliquely addresses Japan’s fundamental problem of stagnant domestic demand.

    T’is a snarky aside, but in addition to serving as the champions of their respective ministries, Nakagawa and Aso also have “issues”. Nakagawa is a loon, though possibly not as intensely wacko as his late father. Aso, for reasons unknown, is the perennial loser in the “stupidest taxpayer in Japan” sweepstakes. He is by no means the wealthiest member of the Diet, yet, come tax time, he is always #1 in the league tables.

  • Posted by B.Setzer

    If China’s peg and growing reserves are mostly a product of domestic political considerations and the US’s inability to reduce demand or its twin deficits are also a product of domestic political ideology, how much influence does that leave third parties to demand changes?

    Everything I’ve been reading lately has been pretty consistent in defining the problems. The current administration claims that everything is going peachy and if anyone has a problem they should make their own adjustments. Equally, everyone but the GOP (Korea, China, EU, IMF, Greenspan, every economist, etc.) is telling the US to shape up or risk destabilizing the current international monetary order.

    Under the status quo, China gets huge growth and Bush doesn’t have to raise taxes. While this program is offensively unsustainable to the rest of the world, it seems like everyone is just waiting for one of these two big players to come to their senses. Isn’t it precisely these sorts of politically motivated if economically indefensible situations that inevitably lead to hugely consequential market disruptions?

    Is there any reason to believe that either party will make the expensive compromises necessary to avoid such a disruption? Can third parties like Japan, Korea, or the EU do anything now to minimize the consequences of inaction by China or the US?

  • Posted by Movie Guy

    I believe that the game is about scale. Scale of production and consumption.

    If so, the game boils down to actions and inactions by the USA and China. Neither intends to make abrupt changes or any changes for that matter for a few years.

    I believe that the third parties are left with very few meaningful options for another 5-10 years.

    This doesn’t mean that the fiscal and budgetary policies of the USA and China are necessarily smart or safe if viewed in the long-term. Obviously not, in my opinion.

    Imagine where the USA would be without massive consumption. We might not be in the big game. If not, we would be making huge budgetary corrections as quickly as possible.

    The 2015-2025 individuals’ retirement funding crisis is what may knock the USA out of the ring. Conversely, Asian growth during the same period will offer new markets for others’ goods and services. Meanwhile, in large measure, the USA will be sitting on the sidelines playing the roles of Merchant Princes hoping for a share of sales opportunities. So, American standards of living probably will driven down as a component of global competition for emerging markets.

    It’s not a nice picture for the USA.

  • Posted by anne

    After years of paying attention to Japan, other than in appreciating Japanese arts I am lost. What then is wrong with Japan or with Japanese economic policy? A rapidly growing powerful economy shows incrasing signs of asset inflation, finally asset inflation begins to be reversed in 1990. By 1992, the stock market is severly depressed and shows no sign of recovery even now. Real estate values begin to decline in 1992. Deflation sets in be 1994.

    Japan has barely grown since 1994, costing the country and the world vast losses in realization of potential growth. There is a tragedy here, but after reading and talking and thinking I am lost in understanding. What is wrong with Japan?

  • Posted by anne

    Paul Krugman wrote that the economic problems of Japan should be an affront to economists. What are the causes of this stagnation? What can be done? Can Japan recover? Possibly well-being in Japan is masked by recorded data and the Japanese are thriving. Possibly Japan is hopelessly aging. I do not understand. Now, a general consumption tax increase is planned during a recession? What is happening? Where is the economic vibrancy?

  • Posted by anne

    We must argue over the problems of Japan, for in a wonderfully developed country there appears to have an economic break that defies fixing. Why should this be so, if so it is?

  • Posted by anne

    When we are worrying about rising asset prices in America, coupled with rising public debt and so little household saving, could find economic growth vanishing as in Japan? What can we learn from Japan? What can we learn from Europe?

  • Posted by David


    This is a little off topic, but what do you make of Greenspan’s remarks this week that the low yield on longterm securities is a puzzle?

    Interestingly, he didn’t buy into the theory that purchases by Asian central banks and others of longterm U.S. securities is the answer. He claimed that yields are also low in other countries which have not had their securities bought sucked up the Asian central banks.

  • Posted by gillies

    movie guy –
    i also believe that the game is about scale – perhaps
    the governor of the bank of england does, too.
    ( G7 speech.)

    “Most smaller countries can choose their exchange rate regime without worrying about its impact on the rest of the world. But the large countries – especially the three blocs I identified at the outset – cannot ignore their interdependency. That is why it is important to expand the group of countries that discuss these issues beyond the G-7 to include those, such as China and India, whose actions increasingly have global economic consequences.”


    it is probably not an original observation to say that free marketsonly fully exist among ‘players’ who own or control a limited percentage of that market. again in the currencies markets we seemto see some players free to move – because they are small enoughto do so without unbalancing the whole market – and others who are too big to move.

    there are two options in currencies – either control is localisedand fragmented so that each player ( national central bank ?)is small enough to be nimble and mobile – or some kind ofglobal currency board, call it the ‘G150’ or something, or evena G 15 with smaller nations grouped under larger representative nations or blocs.

    manoeuvering among a few big blocs is like elephants disputing seats in a rowboat.

    talking is appropriate – cold war style manoeuvering as though your own trading partner was your potential geopolitical assassin, is hopefully almost obsolete.

    why worry about encircling china – when you could just bomb wal-mart ?

  • Posted by anne

    When Greenspan Is Stumped, Investors Should Play It Safe

    WHEN Alan Greenspan says he cannot explain why longer-term interest rates are so low, what’s an investor to do? Take cover.

    Some money managers are doing just that because they have had the same problem as Mr. Greenspan, the Fed chairman: they cannot understand the decline of longer-term rates despite six increases in short-term rates by Fed policy makers since June.

    “This development contrasts with most experience,” Mr. Greenspan said last week in testimony to Congress. “Other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields.”

    Instead, the yield on the Treasury’s 10-year note has fallen to 4.26 percent from 4.69 percent at the end of June 2004, despite a climb of 1.5 percentage points in the central bank’s short-term rate benchmark, to 2.5 percent. While Mr. Greenspan cited many possible reasons for this unusual happening, he ultimately concluded that “it remains a conundrum.”

    That’s enough to make Paul A. McCulley cautious….

  • Posted by gillies

    anne asks –

    We must argue over the problems of Japan, for in a wonderfully developed country there appears to have an economic break that defies fixing. Why should this be so, if so it is?

    japan appears not to grow – and yet has billions of reserves – america grows successfully, and yet accumulates debt. is there any way of making a rough calculation of how japan would fare under a bush style spending of political capital ? and is japan’s interest rate – although very low – actually still higher than greenspan’s when adjusted for inflation / deflation ?

    this might be one place to look for answers.

  • Posted by anne

    Deflation plays tricks with perception. Wages may not rise, but wages buy increasingly more. Interest income may be minimal, but the income buys more. Growth is anemic, but prices are falling so real growth is higher than nominal growth. Besides Japanese statistics do not cover quality improvements in baskets of products. The economy is sluggish but unemployment is below 4.5%.

    The last thing however Japan would seem to need is a tax increase now, but government debt builds and builds. Government debt builds but household saving is high enough to assure a balance of trade surplus. Should there be more debt?

  • Posted by brad

    David —

    I’ll toss out a heretical thought:

    The central bank bid is starting to have an impact on Europe too. Not in 03, when the world’s central banks bought roughly $60b of non-dollar securities. But in 2004. If global reserve accumulation, net of valuation gains, was around $615 b, and central banks added $465 b to their dollar reserves, they also added roughly $150b to their non-dollar reserves (euros, sterling, etc). The gulf oil shieks have large cash balances, but they don’t generally stash them in reserves. But the big oil exporters suppose they put roughly 1/2 of their current account surplus in euros — that might add anohter $50 b of inflows. Since europe collectively runs a current account surplus of 50-100b, that kind of inflow from emerging economy reserves/ oil sheiks strikes me as big enough to matter — among other things, it implies that, in aggregate, European private investors are taking the proceeds from the sale of euros to emerging economies and investing them in the US. Or, put differently, the low yields created by world demand for euros make it attractive for hedge funds to say borrow in euros and invest in dollars, or push european pension funds to invest in dollar debt, either hedged or unhedged.

    Two other parts of the puzzle: Relatively low corp. issuance in the US/ high corp. cash balances, helping to offset low US personal savings and creating a “surplus” of savings; and, in Europe, a regulatory push for pension funds/ insurance cos to better match their assets and liabilities, which is leading to the aquisition of long-term debt. This is also a factor in the US — see McCulley’s article on the PIMCO web page, but less so.

  • Posted by Andrew Boucher

    As everyone probably noticed, France announced on Friday, market conditions permitting, it would begin selling a 50-year bond next week. The 30-year end of the curve took a hit, of course.

  • Posted by anne

    What sort of duration would a 50 year bond have? Will there be derivative products offered on 50 year bonds? Quite some price swings possible.

  • Posted by anne

    “Since europe collectively runs a current account surplus of 50-100b, that kind of inflow from emerging economy reserves/ oil sheiks strikes me as big enough to matter — among other things, it implies that, in aggregate, European private investors are taking the proceeds from the sale of euros to emerging economies and investing them in the US.”

    Why is this an heretical thought?

  • Posted by anne

    Big Oil’s Burden of Too Much Cash

    Born from the megamergers of the 1990’s, the world’s giant oil companies have delivered on their promise. They have cut costs, increased returns and raised profits to records. Now, flush with cash, they find themselves in a paradoxical position – they are making more money than they can comfortably spend.

    Thanks to crude prices that averaged $41 a barrel in New York last year, the world’s 10 biggest oil companies earned more than $100 billion in 2004, a windfall greater than the economic output of Malaysia. Together, their sales are expected to exceed $1 trillion for 2004, which is more than Canada’s gross domestic product.

    But even as fears of shortages grow throughout the world and prices remain high, the cash-rich oil companies are not pouring a large portion of their money into their basic business: drilling for oil….

  • Posted by anne

    Japan is changing:

    A Samurai And Japan Get Samba Night Fever

    OSAKA, Japan – Perhaps it was the equivalent of Americans waking up one morning to find John Wayne transformed into the Cowboy of the Village People.

    For 25 years, on a Japanese television series called “The Violent Shogun,” Ken Matsudaira played an 18th-century samurai who embodied Japan’s idealized masculinity: strong, selfless, interested in neither women nor money, quick to dispense cold justice with his sword and a single order, “Punish!”

    So closely identified had Mr. Matsudaira become with this pop culture hero that it came as a shock when the Japanese found out recently that for the last decade (and hidden mostly out of sight), he had been dancing the samba on stage in glittering gold and purple kimonos, emitting animalistic cries and thrusting his hips. His sword replaced by a coterie of female dancers and a revolving disco ball, he told his fans that in these dark days in Japan, samba was the only thing to do and sang: “Samba! Viva! Samba! Matsuken Samba! OlĂ©!”

    The metamorphosis of Mr. Matsudaira, now 51, into the singing samurai of his revuelike show, “Matsuken Samba II,” caught on wildly in a country where the idealized image of Japanese masculinity has changed drastically in recent years, both in pop culture and in the real world, from stern to soft….

  • Posted by gillies

    ( on japan)

    Despite the advances made by Japan in attracting FDI, its achievements look less impressive when compared to those of other countries. For example, cumulative FDI into China accounts for 35.6 per cent of the country’s GDP up from 0.5 per cent in 1980, according to Unctad.

    Unctad’s FDI performance index which ranks countries according to the flows of FDI as a percentage of GDP paints an unflattering picture of Japan, the world’s second largest economy. The country is ranked 132nd, sandwiched between Burkina Faso and Bangladesh.

  • Posted by jm

    About 20 years ago I had the opportunity to ask a Japanese executive with a broadcast industry background why there were so few radio stations in Japan’s major cities. Even today there are, for example, Tokyo has only four AM and four FM stations.

    His answer was that to go into the broadcast business in Japan one would need first to hire a number of bureaucrats retiring from the related regulatory agencies, at salaries so high it would make no sense.

    There are myriad such barriers to entrepreneurship in Japan.

    Richard Koo’s “Balance Sheet Recession” gives a good summary of other factors hindering innovation there.

  • Posted by Pall

    It’s an old article, but I imagine a lot of the problem persists. Bad debt/bent political & beurocratic system aside, it seems the Japanese economy has pretty much painted itself into a corner.

  • Posted by jm

    Yes. Although the problem of organized crime’s infiltration of the system has been extensively reported in Toyo Keizai and other serious Japanese magazines, it is little understood in the US. The Far Eastern Economic Review article for which you posted a URL is one of the few good reports. But while it does highlight the “suicide” of Tadao Honma, and the murders of several other bank managers, it does not mention the many yakuza firebombings of Japanese bank branches. It also doesn’t explain that some yakuza involvement in real estate has come after the deals went bad, in the form that property owners unable to repay their loans would give them a part interest in order to prevent foreclosure.

    It’s quite likely that the same mechanisms are also operating in China, and will forever prevent resolution of the huge bad-loan problem that continues to grow there.

    Although Asian savings are enormous on paper, in fact a very large fraction of the money has been loaned to entities that have squandered it on projects that make no profit, and so can pay no interest (unless the banks loan them more to keep the charade going). And because of the corruption problems, it is also impossible for anyone even to take over the underlying collateral, even if it has any value. And often the real economic value of the collateral is only a tiny fraction of the loan amount. So in fact probably more than half of the savings exist only on paper, and have no economic substance.