I agree with about 95% of your comment – the 5% is that I think that investing in real assets would be better for China, as it would give them some protection against inflationary repudiation by the US.

I liked some of the links. The Morgan Stanley argument about not enough financial assets sounds ridiculous to me – more aimed at attracting attention than any serious analysis. If the main shortage is in sovereign debt, then surely spreads ought to be historically wide, not narrow. And interesting to see a website dedicated to the tricks played in the calcuation of economic statistics.

I stand corrected on Italy – I should be more careful with my stereotypes.

But adjustment is one thing – joining the US as a reserve currency in BW2 is another…

We all know that current trends are unsustainable. We all know that the current system is doomed. I myself have been explicit recently, in forecasting a collapse (or significant correction) of the Chinese $ peg in June 2007 (or in 2007 anyway).

The issue is: “why worry”!? Why the end of BWII, the end of the US CuA deficit, the US$ depreciation, the shift to a “new system” should be worrisome!?

Now, I AM aware of some risks. But unless we discuss them we cannot evaluate how threatening they are: we will keep hinting at some vague imminent financial tragedies, and abuse adjectives (such as “massive”, “unsustainable”, “unimaginable”, etc.)

As for automatic corrective mechanisms, you think they are slow. I suggested we should not linearize current trends. Some movements are non-linear, exrates in particular. For ex., you don’t announce the break of a peg: you do it. What is reassuring is that (a) forex markets are willing to reduce the US deficit even if China kekeps its peg (b) China is already feeling the pain of too much liquidity, and this is causing political debate over the peg: like in a textbook! So just wait and see.

———-

RebelEc,

I don’t think Rubin and Summers are waiting for popularity to build, I think they’re trying to prepare others that, at the right time, IF imbalances grow dangerous, then we’ll have to have clear and shared ideas about what to do.

I also don’t think asset prices are crazy right now. My ideas, I laid out in July, early August and Sept 2006 in NR’s blog:
- I argued against NR’s “sucker rally” theory, that the Dow (then at 11400) would rise above 12500 by the year end. I also forecasted that it would stay above/ around 12500 at least in 2007:1, thus offsetting part of the housing bust negative wealth effect on US consumption. (I suggested an “almost soft” landing scenario: one quarter of almost zero growth only)
- I forecasted a significant decline of oil prices in 2007 (more if the US and world economy would slow), arguing that – at this stage of the oil cycle – oil is a powerful stabiliser of the world economy.
- I argued with BWS that oil producers’ spending would rise rather fast.
- In October and early November in this blog I forecasted the imminent start of a 10% $/Euro slide.
All these trends are still going on! They support asset prices in the US. You may disagree on asset prices, but define them “crazy” seems too much to me. (Unless you refer to thin spreads: I agree they are too narrow).

———–
Moldbug:

Italy has not a large trade deficit, and its growth rate is accelerating, so Italy can well handle a strong Euro better than others (Spain, etc.) in Europe. Unemployment is falling so EU consumers feel only the benefits of a strong Euro. But a $/Euro at 2 is not needed for US adjustment: according to some of my own calculations, the dollar may overshoot up to around 1,6 in some (worst case) scenarios, not further.

Regards

So evidence of recent acceleration is unlikely to be evidence of impending resolution.

The BW2 governments could be financing the US (that is, buying dollar bonds) because (a) they believe in America and think that American securities are good investments, (b) they are satellites of the American Empire and are paying it tribute, or (c) for domestic reasons that have nothing much to do with America.

In the spirit of the infamous McNaughton memo, I’d put this at 10% (b), 20% (a), and 70% (c). I suspect most readers would agree at least that (c) is the lion’s share.

The BW2ers are buying dollar assets because they have a lot of dollars and don’t want to keep them under the mattress. They have a lot of dollars because they are printing their own currencies and trading them for dollars. They are printing their own currencies and trading them for dollars to maintain their dollar pegs. They maintain dollar pegs because they have mercantilist political alliances to export industries, and the dollar is the currency of most international trade.

In other words, the BW2 countries are running expansionary monetary policies. We know from Austrian business cycle theory that expansionary monetary policy is addictive, ie, a feedback loop. Specifically, it implies a negative dilution-adjusted interest rate, which drive savings out of the monetary system and into capital goods, lowering the rate of return on capital and creating overinvestment in nonmonetary assets – factories, buildings, etc.

(This has recently been rediscovered in the form of the “asset shortage hypothesis”. I’m not sure how anyone whose business card mentions the word “economist” can use the word “shortage” with a straight face, but obviously I don’t work at Morgan Stanley.)

To put this in more concrete terms, the result is that the profitability of many of the enterprises whose shares are currently soaring in Shanghai is extremely marginal. This gives them more, not less, motivation to use whatever guanxi they may have to resist any appreciation of the RMB. China is depending on these very same enterprises to keep a few hundred million ex-peasants busy during the day so they don’t start the next Taiping Rebellion. If solving this problem requires giving everyone in the US a free widescreen HDTV, that’s just what’s going to have to happen, global monetary sanity be damned.

“Diversifying” out of dollars and into nonmonetary assets, while maintaining the pegs, does not solve the problem and in fact makes it worse. It does not reduce the number of dollars that need to be purchased. Its net global result is just to create additional demand for nonmonetary assets. The Fed could do this itself by printing dollars and using them to buy stocks, etc.

“Diversifying” out of dollars and into euros also does not reduce the number of dollars that need to be purchased. And it creates mercantilist political incentives in Europe to effectively join BW2. (Dilute, dilute, OK!) Especially since the European political system is weak, and internal centrifugal tendencies within the euro remain nontrivial. Perhaps Germany can handle a two-dollar euro, but can Italy?

In the context of this inexorable political trap, “inflation” in the Fisherine price-index sense is best defined as a communications tool, which responsible central-bank civil servants worldwide can use to rally public support for efforts to escape the gigantic and horrible whirlpool into which their financial system is sinking. Unfortunately, since price indexes are inherently subjective, they and all statistics that depend on them can be ganked easily and more or less silently, especially by low-transparency governments such as the PRC.

By “outsourcing inflation” – along with most of its productive economy – to the BW2 nations, the US has produced a long period of apparent prosperity. In exchange it has merely scribbled its Hancock on a few scraps of paper and handed them to a tall, dark stranger. Readers wishing to know the ending may consult Faust, Part Two – whose value as a monetary treatise is remarkably unrecognized. (The folks at Barrick, for example, might wish they’d taken a tip from Goethe on the wisdom of exchanging present money for future mineral production.)

I do think some correction mechanisms are in play — the weaker dollar for one, and its impact on US exports. Though right now the weaker rMB’s impact on Chinese exports seems stronger; there isn’t yet a correction mechanism for China’s surplus “in play.”

Higher oil spending is part of the mechanisms for adjustment that is also “in play”; lower oil prices no longer seem to be in “play”

but there are also some headwinds to any correction — low US borrowing rates have kept down the US interest bill, and i do think net interest payments from the US to the world will rise by $150-200b over the next two years, both from the ongoing deficit and from the impact of int. rates on $10 trillion in debt rising from a bit over 4 to somewhere around 5. a 1% shift = $100b.

I don’t think my time frame is all that different from Rubin’s, though I am a bit more forthright. At some point in the relatively near future (next several years), the US trade deficit needs to begin a sustained fall — that hasn’t yet happened. the non-oil balance stabilized when us growth slowed and world growth picked up; ideally it would have fallen. and i currently am worried that the us trade deficit is poised not to fall more but rather to stabilize or rise (if us export growth rebounds my concerns will fade).

I have been more explicit in laying out the risks back in 04-05 — but i also have noted that i (with roubini) underestimated the willingness and ability of china to continue to add to its reserves, and that any forecast that the current system will crack now needs to explain why china will crack.

so in a sense i have tried to back off some of the statements from early 05 — some things that I expected (china wouldn’t be able to sterilize, inflation woudl pick up) haven’t materialized.

at the same time, after a period when i was less worried, i am now getting more worried — the scale of global resreves growth (i.e. central bank financing to the uS) seems to have picked up enormously over the last few quarters, and private investors seem to have lost their (limited) willingness to finance the US (the world is doing better than the US, so why invest in the US?) even as the US still needs a $900b net inflow. This consequently strikes me as a dicey period.

the available data from april suggests that capital flowed strongly into the emerging world, not into the US — Brazil and Russia both reported strong reserve growth. the only way that pattern of capital flows is consistent with financing the us deficit is if brazil and russia continue to intervene massively — both intervened on a Chinese scale in april.

if you have total confident central banks are willing to finance the us, no worries. but if you worry that the scale of financing is now truely “unimaginably larger” then i do think there is a case for worrying more — not less — now. the scale of reserve growth needed to sustain the current system looks to have gotten a lot bigger after say sept. of last year.

Maybe I can catch you before you go to Church!

To reinforce the point I made about plain speaking, I do not think that those of us who like to think we understand what is going on should give an easy ride to the policymakers who wait for popularity to build. Economics is supposed to be a science (albeit an inefficient one, the way academics work), and we should advise action according to way we think things are, rather than the way people would like them to be.

I also think that gradual adjustment is not always appropriate, especially when it comes to asset prices. Assuming that “correct” prices are economically most efficient, you want people who refuse to pay incorrect ones to be vindicated. Those people tend to be despised as timid or party-poopers, and it is easy to overlook their interests. I am not talking about morality here (“the meek shall inherit the sub-prime foreclosure”) although the conclusion might be the same. It is that they represent a stabilising influence that is worth preserving. And, looking at Japan, a gradual deflation of the bubble does not seem to have done the trick (there was a letter about this in Monday’s FT).

I write this partly because I have just listened to World Business Review on the BBC World Service, and sensed a consensus that central banks should avoid a sharp correction.

“The probabilities are extremely high that if we don’t address these imbalances, then at some point, and it could be years down the road, we’ll pay a very big price.” (Rubin)

seems to me very different from the view (that I consider BWS’s view, am I right? Or this is just your old view?) that the sistemic danger for the world economy is now in 2007-08.

Rubin’s satement would be even obvious for any country with a -7% CuA/GDP. Although it is not obvious in the case of a reserve currency country such as the US, since most economists (most of us) easily agree.

But Rubin and Summers are policymakers in their head, and they know that policies take time to be popularised, designed, and implemented. So they warn now about something ahead, so as to cause a change in US policies. I think that’s fair, and it’s not an overestimation of the situation.

Once you start enumerating the dangers caused by the US CuA deficit one by one, you dig into the issues and you find that there is time, time, time, and that global financial mkts are broad and deep. If you look at current macro trends (exrates) without unduly linearizing them, you see that correcting mechanisms are working, although not as those that worry too soon would like them to work!

Perhaps you could help me with my migraine headache problem arising from too much political spin. Treasury Secretary Henry Paulson said on Friday he is “a big believer in a strong dollar”, but also reiterated that greenback needs to be devalued more against the China’s yuan currency. With similar analogy logic, I will inform the police officer that it is possible to be “sober and drunk” simultaneously while driving down the highway with a beer keg displayed in the backseat. Sorry Hank Paulson, it is simply not possible to have a double-standard currency policy with the greenback weak versus the Chinese yuan but strong versus every other major currency under the US Dollar hegemony regime.

http://jp.reuters.com/news/articlebusiness.aspx?type=ousiv&storyID=2007-04-21T030535Z_01_N20334501_RTRIDST_0_BUSINESSPRO-USA-DOLLAR-PAULSON-DC.XML&WTmodLoc=Home-C4-Business-ousiv-8&from=business

Economic imperialism in the age of industrial capitalism provided employment at the core to produce exports to the colonies to earn gold for the home economy. Neo-imperialism in the age of Wall Street finance capitalism relocates jobs to the periphery and imports products manufactured by low-wage labor paid for with fiat currency by the Federal Reserve, the surplus of which can only be reinvestment in the issuing economy. Dollar hegemony emerged as the dollar, a fiat currency since 1971 when President Nixon took it off gold, continues to assume to role of prime reserve currency for international trade, anchored by transactions in key commodities especially oil being denominated in only US dollars. US neo-imperialism is intermediated financially by dollar hegemony.

On the current account deficit, though, he has been quite clear actually — he just (wisely) hasn’t attached a precise time frame to his worries.

Last February (06) Rubin was quoted as saying:

“At some point, these kinds of deficits are not viable,” Rubin said. “The probabilities are extremely high that if we don’t address these imbalances, then at some point, and it could be years down the road, we’ll pay a very big price.”

in bloomberg.

and the title of his 2004 paper with orzag and sinai is pretty clear:

http://www.brookings.edu/views/papers/orszag/20040105.htm

Rubin has been quite explicit (by his standards) about his concerns. In some ways i have a similar problem: both Rubin (in a high profile way) and setser (on this blog and in a 04 paper with roubini) started to worry about external deficits too soon, and warnings of problems that don’t materialize within a certain time frame start to lose credibility.

Rubin also gets tied up in knots over how to reconcile his view of the dollar’s likely trajectory (down) with the “strong dollar policy” — there was a 2006 leonhardt column about Rubin’s lack of skill as an fx trader in 2005 … and his interview with charlie rose is quite interesting on this point. rubin clearly thinks $ depreciation is will necessary to reduce the trade deficit, but he thinks that this is still consistent with a strong dollar policy — as the US would actively take policy steps to encourage the dollar’s fall, and indeed, in his view, should take policy steps (i.e. reduce the fiscal deficit) that would, all other things be equal, help reduce the external deficit in the absence of dollar depreciation. but it was pretty clear that Charlie Rose wasn’t convinced, and that Rubin’s very nuanced strong dollar policy (as strong as possible, given the circumstances, no active measures to encourage its fall) wasn’t quite Rose’s view of a strong dollar policy.

If you are right about Rubin being worried, it is a shame that he does not say so unequivocally. I think this is a problem in economic policy. The figures involved seem to be so guarded that they do not take advantage of their access to the public to spell out forcefully what could go wrong.

This may be particularly important at the moment, when high asset prices seem to be so pervasive. How much better for someone like Rubin to warn people taking out sub-prime mortgages of the risks to themselves, rather than to raise interest rates. In other words, better to shift preferences rather than prices. Public figures give strong warnings about smoking or drink-driving, so why not about risky financial behaviour? They seem to be scared of being seen to be wrong or being loathed by losers if prices do fall, so all we get is weasel words like “how do we know when irrational exuberance has unduly escalated asset values?”.