The balance of financial terror, circa August 9, 2007
Back in early 2004, former Treasury Secretary Lawrence Summers highlighted the emergence of what he termed the "balance of financial terror." China – and others – relied on the US for demand that their economies were not generating internally, and the US depended on China – and others – for financing. Summers defined the balance of financial terror as:
"a situation where we [in the US] rely on the cost to others of not financing our current account deficit as assurance that financing will continue."
The balance of financial terror can also be framed in more financial terms. China has a highly concentrated — and rapidly expanding – position in US dollar-denominated bonds. It depends, wisely or unwisely, on the US to provide a somewhat stable store of value for China's external savings. The United States, in turn, is extraordinarily dependent on China’s government for external financing.
China’s holdings of US bonds are hard to discern in a real time basis, but if China kept the dollar share of its reserves roughly constant at 70%, its $1.34 trillion in central bank reserves – along with at least another $100b stashed away in the state banks – imply that China now holds about a trillion dollars worth of US bonds. That is about 1/3 of China’s GDP. China's growing dollar holdings, in turn, finance much of the US current account deficit. Summers noted the United States growing dependence on the discretionary acts of "political entities" in early 2004:
"There is surely something odd about the world’s greatest power being the world’s greatest debtor. In order to finance prevailing levels of consumption and investment, must the United States be as dependent as it is on the discretionary acts of what are inevitably political entities in other countries? It is true and can be argued forcefully that the incentive for Japan or China to dump treasury bills at a rapid rate is not very strong, given the consequences that it would have for their own economies. That is a powerful argument, and it is a reason a prudent person would avoid immediate concern. But it surely cannot be prudent for us as a country to rely on a kind of balance of financial terror to hold back reserve sales that would threaten our stability."
Since then, the United States' dependence on a single political entity has only increased.
In 2004, China and Japan combined to add around $400b to their reserves in 2004. In 2007, China alone is on track to add $500b to its reserves (counting the CIC) this year: China added $400b to its reserves over the last four quarters, and the trend is strongly up. That implies that China’s government will provide the US with between $350 and $400b of financing this year. Some of that outflow is offset by an inflow of US money into China, but China is still likely to provide at least $300b of the net financing the US needs to finance its $800b plus current account deficit.
If China’s government wasn’t willing to issue RMB bonds – whether PBoC sterilization bills for CIC long-term bonds – to buy dollar assets, the global economy wouldn’t balance. At least not the way it does now. No one else is willing to transform Chinese demand for RMB-denominated financial assets into demand for US bonds.
Yet the United States' large and growing dependence on the willingness of China’s government to continue to act as an intermediary rarely attracts a lot of popular attention. It is just part of the economic landscape, sort of like the United States need to import roughly 14 mbd of oil every day.
But I suspect that there is an underlying unease, a concern that the balance of financial terror may not prove to be as stable as the balance of nuclear terror proved to be during the cold war. Every now and then the United States' need for Chinese financing does attract a lot of attention. Yesterday was one such day.
He Fan (of the Chinese Academy of Social Sciences) published an oped in the China daily suggesting that China might sell (one day) some of its treasuries. Xia Bin (director of the State Council Development Research Center) suggested that China should use its financial leverage to keep a few “silly senators” from setting US-Chinese economic policy. Treasury Secretary Hank Paulson dismissed the risk that China would ever cut off its financing of the US. Chinese financing became an issue in the Presidential campaign. Barack Obama, for example, picked up on Bill Clinton’s (effective) 2004 line on China: "It's pretty hard to have a tough negotiation when the Chinese are our bankers."
CNBC switched from discussing which US company China’s investment authority (or its big banks) might buy next to discussing the possibility that China might not buy any US financial assets at all.
And cool heads – Michael Pettis of Peking University's Guanghua School of Management, for example – appealed for calm.
The general consensus in the US is that China cannot cut off the US without “shooting itself in the foot."
"China would be shooting itself in the foot,'' said Greg Gibbs, a currency strategist at ABN Amro Holding NV in Sydney. “
I disagree. At least in part.
China is already shooting itself in the foot – financially speaking. It loses money every time it buys another dollar bonds. The dollar will depreciate against the RMB some day, leaving China – which finances its purchase of dollars by selling RMB-denominated debt – with large losses.
And, generally speaking, adding to a losing position adds to your ultimate losses.
China would be better off financially if it let the RMB appreciate substantially, stopped financing the US and took large losses now rather than continuing to finance the US, adding to its stock of dollars and adding to the scale of its future losses. A bank that is lending to a failing company reduces its ultimate loss by cutting the company off and taking its lumps now, not by covering ever bigger losses with new loans to avoid “turmoil.” China is in a similar position. The US isn’t a failing company, but China is lending to the US on terms that imply very large financial losses for China.
China’s real problem is that it cannot stop financing the US without shooting its own exporters’ in the foot.
Up until now, China’s exporting interests (perhaps in conjunction with all those who benefit from loose monetary policy) have driven Chinese policy. But the interests of China’s exporters aren’t quite the same as the interests of China writ large.
By the same token, the interest of US firms with operations in China – or US firms that rely on Taiwanese and Hong Kong firms with supply chains that stretch back into China — aren’t quite the same of the interests of the US as whole. There are parts of the US economy that have benefited from China’s policy of subsidizing US consumption, and US borrowing, but there are also parts that haven’t.
This discussion isn’t purely academic. It provides the context for understanding He Fan’s now famous article in the China daily. He Fan’s writings leave no doubt that he understands the financial risks that China is taking by holding so many dollar-denominated assets. Dr. He and Dr. Zhang of the Chinese Academy of Social Sciences wrote in 2006 (in an early verion of this — now restricted — paper):
“Large amounts of trade surplus and foreign exchange reserves have put Asian economies in a position as hostage. Once the global imbalance is adjusted in an unexpected manner, such as sudden drop in the US dollar exchange rate, East Asian economies will be confronted with [a] huge loss.”
He and Zhang think China should adjust its policy to reduce its exposure to the United States. They write:
“continuous growth of [Asia’s] trade surplus is harmful and dangerous …. China’s enlarging trade surplus is closely related with distorted income distribution, losing of job opportunities and disproportional development between [the] manufacturing and [the] services sector. … to absorb the excessive liquidity caused by the increase in foreign exchange reserves, monetary authorities in East Asia [have] to continuously rely on sterilization measure[s], thus limit[ing] the room for monetary policies.”
Their arguments are in many ways the mirror image of arguments that I have made in the past. They don’t think a policy that increases China’s large exposure to the US dollar is in China’s long-term interest, even though it helps China’s export sector. I don’t think a set of policies that leaves the US ever-more dependent on Chinese financing is in the United States interest, even though China’s subsidy of US borrowing unquestionably helps many in the US.
The possibility that China might cut the US off is remote – barring a confrontation over Taiwan. But it also isn’t totally beyond the realm of possibility that China might someday change a policy that many in China think benefits the US more than it benefits China. That is one reason why the balance of financial terror may not be quite as stable as it now seems. The costs associating with maintaining the status quo – most notably the costs associated with China’s huge dollar position – are growing, not falling.
That isn’t to say that He Fan’s argument that a stronger RMB is China’s interest – or similar arguments from Yu Yongding – will suddenly start to drive China’s exchange rate policy. Chinese policy to date has been driven by the interests of China’s exporters, not by the views of the PBoC and prominent academics who worry that the de facto peg undermines China’s monetary policy autonomy. The State Council hasn’t followed Dr. Fan’s advice on the RMB. I would be surprised if it suddenly starts following his advice on its Treasury holdings.
Some on the state council think that creating export jobs now is more important that the size of China’s future financial losses. Some may think the CIC will generate big enough returns to offset the losses from dollar depreciation. Some may hope that the dollar starts to appreciate, allowing the RMB to appreciate without any change in Chinese policy. Some may just be scared of the consequences of change.
A sudden adjustment would be jarring, even if adjustment arguably is in China’s long-term interest. Cutting the US off might reduce the size of China’s ultimate loss on its dollar holdings, but it also would hurt China’s export sector.
One of the lessons of game theory is that threats are costly only when they fail. China, the argument goes, is rattling its sabers to deter the US Congress from passing legislation that China (and for that matter President Bush and Treasury Secretary Paulson) don’t like. But it has no desire to actually carry out its threats.
Menzie Chinn noted in the Post: "It's not really a credible threat."
Still, it is at least worth thinking through what might happen if China did actually decide to carry out Xia Bin’s policy.
Suppose the US Congress ignores the noise now coming out of China and passes a law that materially hurts Chinese exporters. The legislation now working its way through the Congress doesn’t impose across-the-board tariffs, but it would make it easier for US firms to petition for protection from “subsidized” Chinese competition.
Suppose China then retaliates by stopping its purchases of US debt.
In the first instance, China’s exporters – the interest already hurt by US policy – would be hurt even more. The end of Chinese purchases would push up US interest rates, and the resulting US slump would reduce US demand for China’s goods.
China’s trade surplus though wouldn’t go to zero overnight. Nor will China’s intervention in the foreign exchange market. Even if China didn’t sell its existing dollar reserves, it would still need to invest its growing reserves somewhere. And there really aren’t that many options. China would have to step up its purchases of euros.
That would likely push the euro up against the dollar.
And then China would be faced with another choice. It could let the RMB follow the dollar down by retaining its dollar peg amid a trade and financial skirmish. That would at least help China’s export sector: it might be able to make up for the loss of the US market with more exports to Europe.
But it would also cause political problems with Europe. And it wouldn’t help China’s central bank. An even weaker RMB means more expensive imports. It also implies even more sterilization. Since China has borrowed RMB to buy euros as well as dollars, it also means financial losses for the central bank.
Perhaps most importantly, so long as the China kept its peg to the dollar but put all its assets in euros, it effectively would be generating massive ongoing pressure on the dollar – and thus on its own exchange rate. Moreover, as Francis Warnock notes, the Federal Reserve would respond to a fall off in Chinese financing that raised US long-term rates and slowed the US economy by cutting US short-term rates.
The pressures on the dollar would only grow. Forget 2 dollars to the pound. Think 2 dollars to the euro.
Alternatively, China could allow the RMB to appreciate against the dollar to keep its own exchange rate from depreciating along with the dollar. That makes a certain amount of sense. It seems to be the policy He Fan is advocating. Why after all should China tie its currency to a sinking stone? Why should it allow the US – whose trade policies, after all, started the whole mess – set China’s exchange rate policy?
But such a policy change would hurt China’s export sector. And it would effectively hand the US a victory. If the dollar fell v the euro and the RMB rose against the dollar (i.e. the dollar really depreciated), the US would in some sense get what it wants …
And if I had to guess, I would bet China won’t actually change its policy of pegging to the dollar and financing the US even if the US passed legislation that China doesn’t like. How, after all, did China respond to the US decision to block CNOOC’s purchase? Judging from the ongoing increase in China's reserves, by buying even more US bonds. China wasn’t prepared to hurt its export sector by slowing its purchases of US debt even after the US Congress effectively blocked a part of China’s energy policy.
But there is little doubt that China is becoming increasingly aware of the costs of its current policy – and increasingly frustrated at the US.
He Fan believes that the RMB should be allowed to appreciate, but his oped also clearly indicated that the US should not try to dictate the pace of RMB appreciation, particularly given that the RMB/ dollar is a key price in China’s economy.
“The exchange rate equals a price between between currencies in economic theories. Price is the key to allocating resources. …. It would be totally against the rule of the market economy when a country, through a political course, asks the Chinese government to change a key price in the economy.”
That is probably a typical attitude. No one likes having another country tell them what they should do – or tell them what is in their own interest.
But He Fan’s argument suffers from one important problem: the RMB/ dollar isn’t just a price that matters inside China. It also has become one of the most important prices in the US economy – and indeed the global economy. The US Congress is uncomfortable allowing China to continue to set a key price in the US economy. Larry Lindsey got this right in 2006: the US is uncomfortable letting China – really China’s government — pick winners and losers.
"The matter of principle on which the American political process is now becoming focused is that it is the Chinese government, not our political process or the independent determination of markets, that is determining the result. We are buying more tee shirts, shoes and appliances and living in larger homes than we otherwise would because of a Chinese government decision. We are producing fewer appliances and less agricultural output than the market would have us make as well, thanks to a decision by the Chinese government. It does no good to tell American politicians that if the Chinese want to subsidize us we should let them, because the very fact of their subsidy changes our behavior in a way determined by them, not by us.
American frustration with the slow pace of RMB appreciation is growing – as, I suspect, are concerns about the scale of the United States dependence on Chinese financing. As China shifts from buying bonds to buying companies, the extent of that dependence will become a lot more visible.
China wants the freedom to set the pace of RMB appreciation on its own. But so far the pace of RMB appreciation that has proved politically acceptable has been too slow to do anything more than offset the dollar’s slide – and far too small to slow the growth in China’s trade and current account surplus.
China’s concentrated financial position and growing dollar holdings– at least in my view – are neither good for China nor good for the US. China is too exposed to further falls in the dollar. The US is too dependent on a single source of financing.
Yet unless something changes, China’s concentrated exposure to the US and the United States dependence on China will only grow. That hardly seems healthy.
China’s insistence that its exchange rate policy its own sovereign choice – something that it and only it can set, no matter how large the impact of its choice on the rest of the world, isn’t helpful. Nor, for that matter, is the Bush Administration’s apparent decision to making cutting the US corporate tax rate its highest economic policy priority. A corporate tax cut isn’t going to address American workers’ concerns about globalization.
The time to find a constructive solution is growing short.
UPDATE: I edited the initial post, which among other things left out a crucial "not".
UPDATE 2: China's July trade surplus came in at $24.4b — call it $25b. Exports increased by well over 30% (almost 35% actually) year over year. The ongoing surge in China's trade surplus — and the implied increase in Chinese foreign asset accumulation — only reinforces the need to find a constructive solution. Fast.
First?
Beautiful title! The balance of financial terror!
But isn’t it more difficult than predict recessions?
Of course, something in financial world needs some balancing.
PS: Circa today is LOL.
all credit for the title should go to Dr. Summers — he coined the term.
Very nice post. We are not paying enough attention to this at this side of the pond, and that worries me. Balance of terror between two parties may work, but with RMB/euro (and USD/euro) there is increasingly a third player involved. It gets very complicated, and to the engineer in me complicated means fragile.
If China let the market to set the yuan’s value, then I suppose they should buy a lot less US bonds. That would make similar, although less severe, problems to the US than China selling its existing US bonds.
I think a major change in Chinese economic policy (like a sudden yuan appreciation) would almost certainly cause a major economic, and maybe political turmoil in the world. I doubt that China wants to ignite such a turmoil before the Bejing Olympics is over. Maybe after that. Although, in 2010 the Shanghai world fair is coming up…
Thanks Brad. An excellent and balanced post!
You’re as objective and polite as most of the time, but your concerns are growing…
You mentioned quite a lot Roubini&Setser paper of 2004, as giving excuses for being wrong. You were probably right, but invisible hands made things to go on longer than you suspected.
Because of that you are more concerned, because you feel alone in the desert, giving solutions to deaf and blind (in both sides of the ocean).
They are sovereign and don’t listen to anybody. They know what to do in any situation.
The worst thing is that lately, when they made a decision, it was for the worse: cutting taxes to ultra-riches and spreading democracy in Iraq.
So, it seems that a financial fright, scare or terror, could bring some correction, if lot’s of investors and financial corporations went out of business and governments were to worried of their citizens.
It’s a pity that a sanguine man, like macro man is vacationing (not sure a day as today), and Twofish is busy in his business.
Today, J. Stiglitz wrote a nice page in ShangaiDaily (you probably read it) speaking clearly. It’s very well-known for everybody in this blog.
http://www.shanghaidaily.com/sp/article/2007/200708/20070809/article_326522.htm
Stiglitz gave up the World Bank, but his beliefs are the same. Probably, in 2008 you’ll say that you’re were explaining clearly what was happening 4 years before, but you were alone in the desert.
Go on and my hat to you!
PS. I’m very sorry or my last comment (after two gin-tonics), for talking about missile-makers and some gulf state. I appreciate very much your blog and learn a lot from it. Sorry, again, I promise I’ll be politically correct!
As a Chinese who lived in the US for about 10 years, I sincerely think the two governments should negotiate a way out of this “financial terror”.
Quite some time ago on this board, I suggested a possible re-balancing path. The US (Fed) promises to hold the short-term rate at 6%, and China (PBoC) promises at least 6% per year RMB appreciation vs. the dollar.
The US will get a recession due to this arrangement. But it will have fewer deficits and people will save more.
The Chinese exporters will also get hurt, but China will get less unwanted surplus and less external exposure after this unwinding.
The burden of adjustment needs to be shared by both sides. It is in the interest of everyone in this world that we can get out of this imbalance smoothly and gradually.
But of course it is the most powerful that should be the largest debtor. How could it be the other way around? And inside a nation the largest debtor is naturally the sovereign. This is how credit economy functions. Otherwise you have deflation. I hope Dr. Summers didn’t suddenly turn Jeffersonian on monetary issues (as opposed to Hamiltonian). That would be a scary thought from an ex-Treasury secretary.
That aside, it seems that US tariff on Chinese exports is in China’s interest as well. For one it actually protects China’s existing dollar holdings if it put a brake on US consumption. It also gives more time for China to adjust than a large reval (which impacts all trades instead of just Sino-US trade). But all the sabre rattlings make it hard to have a true debate over the benefits.
what about mcculley’s assertion that what china gets in exchange — “superior know how, institutions and political stability” — is worth the price of admission (reserve losses) for a developing country? i.e. they now have world class infrastructure (if not pollution controls) and a manufacturing base. now they’re working on financial ‘infrastructure’ — corporate bond market, derivatives trading, etc. — altho there’s a chicken-egg problem w/ the closed capital account and peg, which arguably retards their financial development. also it might be the development of their military infrastructure that could be alarming congress at this point… as well as the FWMD threats of course.
mcculley’s larger point, that politics is driving this as much as economics, is welcome. and like twofish has said, there are positive aspects to BWII; focusing on the negative is not the whole picture, prima facie, else it wouldn’t have gone on as long as it has, even as “costs associating with maintaining the status quo … are growing, not falling.”
your analysis ignores the multinationals — probably been the biggest beneficiaries from BWII — who certainly have vested interests (offloading costs), political pull (on both sides) and the lobbyists/$ to go with it… and like if paulson goes to blackstone, like when bush went to carlyle or snow to cerberus, you’ll know he’s been bought and paid for. like the joke that china should be able to appoint the treas. sec’y has come true. imagine that!
i’ll leave you with this thought from blair, which i thought was particularly insightful, relayed by brooks from an AEI panel discussion i caught on CSPAN
“Though Left and Right still matter in politics, the increasing divide today is between open and closed.
“Is the answer to globalisation, protectionism or free trade?
“Is the answer to the pressure of mass migration, managed immigration or closed borders?
“Is the answer to global security threats, isolationism or engagement?
“Those are very big questions for US and for Europe.”
I think china already has most of the necessary know-how on the manufacturing side, with a few exceptions. the next textiles or auto parts or electronic components factor doesn’t add that much to China’s stock of knowledge. On the financial side, as you hint, I would argue that the peg stymies meaningful financial reform, and thus retards the emergence of a world class financial system. credit controls, administrative caps, deposit floors and lending caps and the like are all become more not less entrenched — as if the use of non-market sterilization techniques. At the margins the cost are growing (i.e. the expected loss on China’s dollar reserves as well as growing global frustration at chinese policy — and i say that knowing their global frustration at some aspects of us policy as well) while the benefits seem to me to be shrinking.
fully agree tho that some very concentrated interests (MNCs, parts of the financial sector) strongly support the peg. a while ago i wrote a post about how the standard framing of the political economy of trade — one that argues that the concentrated interest of those who don’t want trade tends to overwhelm the diffuse interest of consumers — ignores both the very concentrated interests who benefit from the us-china trade (firms) and have effectively driven the substance of us policy to date, tho not the tone of us policy and the diffuse interests that are hurt — the workers who compete with workers released from the manufacturing sector (yes, employment the manufacturing sector would be shrinking w/o china as productivity increases, but it wouldn’t be shrinking quite as fast …)
China could sell all its bonds and all its dollars. The rest of the world could sell all its bonds. But the rest of the world can’t sell all its dollars.
The effect would be to force repatriation of all bonds to the domestic US in exchange for dollar bank deposits.
The CA income account would improve because the bank cost of funds would be lower than treasury interest costs. The cost of new treasury financing would increase, but so would the yield to the financial institutions and households that bought them.
“…there are a lot of folks quietly making a bundle of money while the markets crater…” http://www.forbes.com/home/opinions/2007/08/06/croesus-chronicles-indexes-oped-cz_rl_0807croesus.html
jye,
Sounds good to me. While we could quibble about details, I wholeheartedly agree with your sentiments. Nor is such an approach unprecedented - that’s what the 1985 Plaza Accord was about.
Unfortunately I am not in a position of authority in the US government, and I’ll presume that you’re in no such position in the Chinese government. I don’t think either side is serious about negotiating to fix this problem.
“…”The Bank is closely monitoring developments, and will deal with issues as they arise.” The bank’s website indicates that the last time it issued this sort of public reassurance was following the Sept. 11, 2001, terrorist attacks in New York and Washington…” http://www.globeinvestor.com/servlet/story/RTGAM.20070809.wtsxo0809/GIStory/
“…An important question is why interest rates spiked and why the ECB felt it had to intervene. A generalised loss of market confidence should be easy to stabilise, but if the market has got wind of a specific problem at a large bank then the situation is more dangerous…” http://www.ft.com/cms/s/db33602a-46c4-11dc-a3be-0000779fd2ac.html
well if both sides are beginning to feel like it’s an unhealthy relationship the ‘divorce’ can either be acrimonious or gracious. i doubt the latter, but maybe a trial separation is best for all involved so that china can concentrate more on its own internal (emotional balance, honesty) development, while the US works on physical therapy of its atrophied tradeable goods sector (universal coverage would be a good start). maybe in a few years time they can get back together on a more mature level
who knows!
btw, one thing i find a little heartening about all this market turmoil is that as money flows out of private equity and hedge funds, it seems like it’s making its way back into VC (as xie would have it) and what has shined thru? clean/green tech… the market, apparently, has identified a need, even while property developers are eyeing green-newfound-land (denmark should sell it to the netherlands, imo
and canada and russia claim the arctic!
with that, i’ll leave you with this thought from khosla, capital and information flows, but “Science and technology, powered by the fuel of entrepreneurial energy, are the largest multipliers of resources we have to solve our many social problems.”
“…the unprecedented step of offering a pre-announced unlimited tender so that European banks could get as much cash as they wanted. The last time it stepped in to provide large-scale liquidity in response to market concerns was in the aftermath of the September 11 terrorist attacks. But even then, it did not offer unlimited support. Equally striking was the amount of money the 49 banks that took up the tender received…” http://www.ft.com/cms/s/569c9418-46a0-11dc-a3be-0000779fd2ac.html
US could enact an automatic tariff on all imports that turns on when C/A deficit exceeds 4% of GDP and turns off when it is below 2%. This is just to balance the large imbalance in preference for current consumption among countries. Because of the automatic trigger it can be demonstrated to other countries that it is not protectionist (and they are welcome to implement similar triggers which would be moot point for surplus countries).
“…the Asian Development Bank pronounced China, alongside Nepal, to have the most unequal income distribution in Asia… improvements - for example, strengthening healthcare, education, infrastructure and environmental protection - will come at a cost. Others - such as stemming corruption or enhancing property rights protection - will pay for themselves. The government must carefully weigh any such reforms against their effects on economic growth…” http://www.ft.com/cms/s/1e938d5a-4697-11dc-a3be-0000779fd2ac.html
re: “when C/A deficit exceeds 4% of GDP” - per country, or collectively?
like carbon credits you could start trading CAD credits! lulz
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President Hu’s administration, suffering from a string of embarrassing scandals, is moving to take authority away from China’s powerful local governments.
HSBC plans to open a bank in a Chinese rural area, the first foreign institution to do so as Beijing pushes to develop services in the hinterland.
Carbon Credits to Help Papua Preserve Forests
Papua’s governor is hoping global investors will pay the Indonesian province not to cut and burn down its pristine rain forests. His proposal: Have Papua become an active player in the world’s emerging carbon markets. Without funding, Papua may need to hand over huge tracts of land to Chinese and Malaysian plantation companies.
Chinese firms are likely to become the largest group of foreign companies listed on Nasdaq by the end of next year, Nasdaq’s vice chairman said.
The Lindsey comment you quoted, which has been ignored by your commenters, is the crux of the matter as far as I’m concerned.
This “arrangement” has enormous political and social consequences which have, up to now, been ignored.
CNN seems to be speaking for Brad’s “concentrated interests” when it says:
Nor does the U.S. have much to gain from such a scenario, despite the protectionist rantings of the Democratic presidential candidates. Most of the foreign companies that invest in China are American. They’ll be hurt just as much as the Chinese.
That’s why U.S. Treasury Secretary Hank Paulson — an expert on China while at Goldman Sachs (NYSE:GS) — is telling everyone to cool the rhetoric. Trade with China is a benefit, not a drag. We hope everyone — including China’s government and Congress — will listen.
[Italics mine.]
http://money.cnn.com/news/newsfeeds/articles/newstex/IBD-0001-18765249.htm
I, for one, am tired of these special interests running the globalization show, although I will readily admit not much can be done politically about it until after a great more damage is done. CNN is just one of the many mouthpieces for special interests–as are economists who parrot the glories of globalization without paying any attention to how it has been structured and advanced.
Aside from a few posts on AngryBear, where is there any in-depth discussion of GAT or of the WTO rules.
At some point, even economists will have to look at the body that runs the show, the WTO–for the special interests. No heed is paid to labor. None…and for very good reasons: Profit, not the distribution of wealth (the rising of all boats), is the name of the game. The ILO is a joke. If GDP per capita in China is falling, whose boat is rising?
The usual, unthinking answer to my complaint is that I must be a protectionist; after all, you are either for globalization or you are a protectionist. There has been a serious failure of intellect among those who praise globalization no matter how it is being conducted. Capital is being allowed to pursue any path it desires in the name of more profit, as long as the rules within a country are the same for all businesses. The WTO sees no harm in this.
NAFTA was sold to Mexicans and the Americans as being unquestionably profitable to both. Yet the flood of illegals has not abated, despite the fact that Mexico now enjoys a nice trade surplus with the states. No boats rose. None. Yet liberal and conservative economists paid no heed to the voices that said that Mexican labor must be protected: The right to unionize, to bargain collectively, outside of government control. In the end, both Americans and Mexicans suffered.
This whole thing is a joke.
If the WTO cannot set up sensible rules for entry of countries into its august chambers, I would tariff those goods made directly or indirectly by our firms in undeveloped countries. Pay a little more for your Ipod, whose hourly production cost is now somewhere around seventy cents an hour. Use the money to pay down our debt, to created better health care and infrastructure. Our companies in undeveloped countries are making a handsome profit…very little of that profit makes its way into U.S. government coffers. And none makes it into the hands of the poor laborers. The rich get rich on the backs of the poor everywhere…and think they deserve it for being so entrepreneurial and wise.
agree that lindsey framed the issue accurately. the hard part for China, i think, is recognizing that its policies and actions now have an impact far beyond its borders. the hard part for the US is recognizing that China is now acting in some ways like the US sometimes acted in the past — relatively impervious to external pressure, and determined to do things its own way, no matter what the consequences for the world.
i also liked the trial separation metaphor, and would second the general idea that china needs to concentrate more on its own internal development, and the US on the development of its “atrophied tradeable goods sector” — but, obviously, incentives matter, and the key incentive here is one rather important price.
What is amusing about this discussion is how the US tells China it should do X because X would be good for it. If X were not really super-good for the US, the US wouldn’t give a fig whether it were good for China or not. I seek a word to describe the US’s motives: hypocrisy is not quite right. There must be a better word for pretending to be concerned about another when you are really only concerned about yourself.
2007-08-10 01:38:45 - it’s called reciprocity, with the US’s concerns being increasingly influenced not only by American-Chinese but a whole bunch of other NRs, dual citizens, trade partners and its massive interests around the world which are all being affected by this. If reciprocity, not only with other nations but its’ own citizens at home and abroad, is a concept that Chinese authorities fail to fully appreciate, they will be forced to understand it.
This blog would improve if you actually got some comments that responded directly to the numbers you so thoroughly review and your analysis of them - and a little less chase-the-tail blame game or completely off-topic stuff.
Brad — I like your writings very much, and learned a geat deal from them. But I don’t understand your insistence on China loosing a lot on the dollar peg or slow appreciation. You should think more strategically. The few trillion dollar China may loose is peanut money compared to the potential benefits of lifting hundreds of millions out of poverty and into a modern economy. If China sticks to the policy of slow and measured changes it has been following in the past decades, then 20 years from now they will be capable to make everythig from microprocessors to wide-body aircraft and nuclear submarines and aircraft carriers on their own. And will have a middle class twice as big as the entire population of the US. And at the same time, 20 years from now, the US will still be in Iraq making promises that this time we really are going to get the bad guys.
Brad, anybody, I have a somewhat provocative question -
but let me first say that I sincerely hope it never comes to a situation where this becomes an issue.
This said, I am wondering to what degree the US could - in a situation where selling US bonds was used strategically against it by some sovereign entities - selectively default on bonds held by the Sovereign in question. I guess this depends a lot on where and how these bonds are physically held, but am no expert on these issues. Also, to what degree/ how quickly would we see if a sovereign was transferring its US fixed income holdings to entities where it would become impossible for the US to know their true owners?
if someone is shifting their bonds out of FRBNY custodianship, the US would know in real time — and i think it is relatively speaking technically easy for the US to not default per se but to freeze an asset held in the US and basically make payments into a locked account.
doing so tho in the face of the act of selling a us bond — rather than after a coup or something similar (the us froze a lot of iranian assets) tho would be something new, and i think the us would need to worry that others, who haven’t had their assets frozen, would suddenly become a lot less willing to hold assets inside the us.
yes, off topic comments can be a bit of a problem. but getting a detailed discussion of numbers going is hard, and in this case, my post was all words and thoughts, not hard data.
AC — i tried to lay out why i think the US and China would both be better off with a stronger rmb and a smaller us deficit (and smaller surplus) — i think your account leaves out the domestic problems china’s huge reserve growth is causing china (well laid out by he fan), the financial losses china will incur subsidizing the us, and the costs the US will incur when it has to go from paying for its import bill by printing IOUs to paying for its imports by exporting things — Larry summers, in one of the articles i linked to, notes that countries almost always hold on to fixed exchange rates for too long. i think that is the case here.
guest (overnight) — Not only is the US telling China what is in China’s interest, but now China is also starting to try to tell the US what is in its interest — look at he fan’s article, which argues that the current exchange rate is such a great deal for the US that the US should back off and let china move at its own pace, since the only ones hurt (implicitly) are those in China who are subsidizing US MNCs and US borrowers. Remember, a lot of folks in china — and notably at the Chinese Academy — think that the problem with the RMB/ $ peg is that it is a far better deal for the us than for china, and thus don’t understand us pressure.
I think their argument equates the US with US firms a bit too much, and focused on the financial benefits to the us from cheap financing without focusing on the distortions created by these flows, but the argument is still important.
Rumored that the European Central Bank is extremely angry at the conduct of the US Federal Reserve. Over the past decade, the Federal Reserve has been sleeping on the job in their oversight of the US Banking system. No one really knows how much bad debt in subprime and Alt-A mortgages there really is.
As he is nicknamed by the Chinese, “Little” Bush has no credibility in China. Everyone is of course entitled to their own opinion. - Dave C.
President Bush makes counter threat to Chinese over US currency
http://www.washingtontimes.com/apps/pbcs.dll/article?AID=/20070810/BUSINESS/108100041/1006
President Bush said China’s option to use its foreign reserves to weaken the dollar and spike U.S. interest rates would “absolutely” hurt China more than the U.S.
Mr. Bush said he had not seen the London Daily Telegraph report that Beijing was hinting at such a move but warned against any attempt by China to hit back at Washington using vast foreign currency reserves.
The ‘we know what’s best for you’ used to be called ‘missionary diplomacy’ and is something now rejected totally by the Chinese in word and in deed.
I wonder what the effect on markets would be if the Chinese were to peg to gold - or to buy gold instead of currencies.
And why worry when a central bank loses money on its assets?
Selectively defaulting is like being half-pregnant. It doesn’t make sense. Either you are paying or not. In any event, there is no provision in US law for stopping payments on treasuries.
Stormy: I, for one, am tired of these special interests running the globalization show.
Other people’s interests are always “special interests”.
Stormy: No heed is paid to labor. None…and for very good reasons: Profit
There’s also the problem that labor is not uniformly against globalization. One of the most powerful unions in the AFL-CIO is the longshoreman’s union, and they are dead set against anything that interrupts trade and their jobs.
The other issue is that industries that are hurt by globalization tend to just disappear, whereas capital that is made by globalization remains.
Stormy: If GDP per capita in China is falling, whose boat is rising?
It’s not falling.
The trouble with your perscription is that it ignores that the fault lines aren’t where you think they are. It’s not capital vs. labor or rich vs. poor, it’s longshoremen versus auto workers, or Chinese peasants + Wall Street financiers vs. sugar producers + auto parts workers. Each battle has it’s own constellation of interests. This means that its very easy to destroy a protectionist movement by giving favors to one industry to the point that they don’t care about other industries.
re: “wondering to what degree the US could - in a situation where selling US bonds was used strategically against it by some sovereign entities - selectively default” - ‘we’ve talked about selective default before; for ‘me’, once you’re at the point of seriously considering selective default, the game is already lost - it’s the (tactical) nuke option of the financial world… imo there’s no such thing as a ‘limited’ nuclear war; after it’s used the world (financial system) will never be the same…
but then again, after BWII is dissolved (in one way or another), it was never going to be the same… so lemme plug ‘my’ 2007-06-26 17:00:23 comment
cheers!
Beyond establishing ‘true owners’ whether the bigger question is liability holders - and if a global ‘liability crunch’ (political and legal) is the driver of the ‘liquidity/credit crunch’, what the CBs are to do about that. Whether the real problem is a balance of liability terror.
BTW, any idea what deals Paulson struck with the Chinese in his recent trip to Beijing? I don’t see any inside scoop leaked to the press.
guest — maybe you should post your 07-06-26 comment here — finding it is a bit of a chore, and it seems relevant.
agree that my comment on selective default (tho justing paying into a blocked account that cannot be used is a way of defaulting without technically defaulting in a legal sense — having worked on em default/ restructuring, i know the tricks of the trade ..) was a bit blase– i didn’t emphasize enough the point that others would react in a way that basically destroys us assets as a reserve currency (unless they are held offshore in complicated ways). you are right that it is the equivalent of tactical nukes.
second guest: isn’t the answer to what the central banks are going to do about it “open the discount window and lend” — fed bought a bunch of MBS this am, per bloomberg. not really sure what you driving at — i find your comment a bit cryptic.
Interesting to think about possible UK repatriation flows given The City’s international population and interdependencies: “…However, BNP Paribas’ Stannard also points to the positive sterling flows that could come from repatriation flows back into the U.K. from U.S. corporate bond markets…” http://biznes.onet.pl/5,1586290,wiadomosci.html
If it might be instructive to consider ‘offshore’ centers’ role: “…Why was a mid-sized Dutch bank playing in the US mortgage market in the first place?…” http://business.guardian.co.uk/story/0,,2145760,00.html - “financial naivety” - not!
“Mr. Bush said he had not seen the London Daily Telegraph report that Beijing was hinting at such a move but warned against any attempt by China to hit back at Washington using vast foreign currency reserves.”
The US is not in a position to be making threats to anyone at this stage … particularly because the crisis is completely our own doing.
Pete, CA
Brad, Summers’s balance of terror image is grimly risible. It’s like saying, “You can’t nuke us because it would cause nuclear winter.”
The response might well be, “We’ll take our chances.”
Related news: China’s July goods trade export is 107 billion USD, up 34% y/y. Trade surplus: 24 billion.
re: “if the Chinese were to peg to gold” - they already (ostensibly) have a basket peg and altho i like ron paul i don’t think the gold standard works in the ‘modern era’ (to the extent that you believe an economy can be ‘post-industrial and/or service/info-based, much less debt-based
BUT i think there is room for a commodity-reserve currency as originally envisioned by graham and promoted by keynes (which was rejected in favor of what we now know as bretton woods). not as a total replacement of CB fiat or even gold, but as a complement… and china is already setting up a strategic mineral reserve in addition to its SPRs; so it’s not all craziness! btw, carbon/pollution credits and catastrophe bonds might also (someday) prove to be useful as a ‘reserve’ holding…
Anon: BTW, any idea what deals Paulson struck with the Chinese in his recent trip to Beijing? I don’t see any inside scoop leaked to the press.
Real deals are rarely made at these sorts of meetings. Too much press attention to do actual negotiation. These meetings either ratify deals that have already been made, or they serve as a chance to pass information that will allow people to figure out what deals can be made.
In reality, policy making tends to be much more open and messy than most people think it is. There are so many people that can veto/break a deal that to get any real deal together, you have to communicate in a fairly open manner.
re: “maybe you should post your 07-06-26 comment here” - happy to oblige - i guess if you feel like BWII won’t be around too much longer, it’s worth thinking about what might replace it and how, esp if the “we’ll take our chances” attitude is becoming prevalent…
—snip—
well, there’s risk-free and there’s ‘risk-free’ (at what inflation and fx rate - again translating between nominal and ‘real’?) my question/rumination was whether the US can actively select who bears the ‘risk’; again (again), i agree w/ you that the whole edifice crumbles once credibility goes (money, afterall, is an agreement, as lietaer would say).
like if i say to one creditor, yes, and to another, no, then obviously even the one i say yes to would be suspicious (w/o assurances), esp in an iterative process; hence the advent of credit history and all the rest. but if the house of cards is crashing down _anyway_ what i was wondering is if the US could keep enough of its (’select’) lenders together, while singling out a scapegoat (in DC’s terminology) as the sacrificial, well, goat, in order to minimze the carnage — to itself, and to it ‘allies’.
in effect, the US would be saying yes, yes, yes to most of its ‘well-behaved’ creditors, but no to a few (or one) of its ‘enablers’, essentially telling them they’re assholes and deserve it anyway and turning the neo-washington consensus (in the BWIII club) against them for the ‘good’ and the preservation of a reconstituted monetary system in a newly tiered world.
again^3, somehow i doubt this would work, if only because most of the productive and resource (and intellectual?) capacity lies outside washington and if BWI & II never worked, why would III? beyond a “multi-polar currency regime” as DC advocates, i’d submit a back-to-the-future buffer stock solution ala graham and keynes (the terra?) perhaps coupled w/ non-national local/private currencies…
not that gov’t (tax-payer) backed fiat currencies are inherently unstable, it’s just that they’d work better when they’re not the only choice around; the right currency for the right niche, a currency ecosystem as it were (similar to all the different software licenses that abound) that would better reflect the system of values of its constituents… only the ‘right of kings’ — to coin money — is zealously held.
***end***
while a ‘currency ecosystem’ is admittedly extreme and unlikely in terms of conventional wisdom (to be galbraithian) — we will not be w/o gov’t controlled currency anytime soon, and any replacement to BWII will be focused on a basket of CB fiat currencies imo (and DC’s) — i strongly feel that going back to fiat (or gold) would be a mistake* as globalisation has i think impaired effective CB stewardship of the monetary system, if not rendering it wholly obsolete… ask yourself, why are we even talking about any of this (some of us, for _years_) if there wasn’t something fundamentally wrong or broken with global central banking as it is currently constituted? not that it necessitates a ‘paradigm shift’, just that thinking ‘outside the box’ may provide a useful recourse towards long-term sustainability and better living standards for _everyone_, which i submit should be a relatively uncontroversial (and therefore achievable?) goal.
—
* i am sympathetic to mcculley’s ‘gold standard’ for the 21st century tho…
http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2004/FF0604.htm - “The modern day equivalent of the gold standard is, I submit, a nominal rate of interest on money that makes the holder whole for the two taxes that our government imposes on money: the explicit tax on nominal interest and the implicit tax of inflation.”
It appears that the Fed is trying to accomplish a fix by applying its tried and true (up until now) remedy of pumping liquidity into the markets. As Nouriel pointed out, this might help the liquidity shortfall that is a result of the current crisis, but will offer little in the way of a solution for a credit portion. The markets will probably be forced to realize this fact. It is interesting that the current crisis is a result of the very same liquidity pumping that has continued for years. Of course, the markets will temporarily believe that this is the answer to the problem. It is very similar to the plans being promoted for helping out the homeowners who are struggling with mortgage problems by throwing more money their way. We figured out a long time ago that the answer to home fires is not to hire an never-ending number of firefighters, but to work harder at preventing fires in structures in the first place.
This may very well be the most direct example and proof of the way the President’s Working Group on Financial Markets actually operates. Although a never-ending stream of government officials have recently been pounding the pavement insisting that all is well and very contained, the Federal Reserve has suddenly seen fit to invoke “emergency” measures in what must clearly be a response to the fears of a stock market meltdown. The result of their press release today certainly had the effect of “plunge protection.” Once again we buy a little ‘time.”
re: “there is room for a commodity-reserve currency” - disagree as I think that ‘money’ has already evolved as a flexible pricing mechanism that is being adapted to express the values of everything - wealth and stores of value being more dependent on the extent of anyone’s/entity’s capacity to establish and protect valuations, entitlement (legal or by force) and demand for anything that the world may want at any given time. commodity hoarding could make some targets of blowback - no oil - no water - no wheat - no tech - no market etc. - and victims of innovation - such as oil hoarding prompting massive cutbacks in use and improvements in alternative energy sources etc. - but the value of everything still has to be expressed through some sort of universal pricing mechanism.
if you’ve read J. Orlin Grabbe’s End of Ordinary Money - his conspiratorial and rabidly cynical views are over the top, whether his technical stuff is interesting to you.
Brad, to what extent could the Chinese have, over the past few years, hedged some of their massive USD FX exposure, either directly or through State banks? Clearly the market would get wind of positions of this size being placed over a short timeframe (and where they were coming from), but given a several year timeframe, could this, theoretically, have gone un-noticed? USD depreciation has been a known risk for years and the folks at SAFE are not big on taking losses and are nothing if not prudent (tho I bet they’re feeling some of the mortgage fallout pain themselves) - just curious…
This goes to the point made of China shooting itself in the foot by dumping USTs. Perhaps they’ve already hedged against some of the pain?
Marc August: The result of their press release today certainly had the effect of “plunge protection.” Once again we buy a little ‘time.”
Until of course the big disaster that destroys everything. Since we want to avoid the big disaster in the future, the logical thing to do is to create the big disaster now.
I’d like to at least offer a somewhat different view, that through a series of short term fixes can postpone the “great awful disaster” indefinitely, and that people that want to “destroy the economy in order to save it” may be looking at things the wrong way.
bsetser: On the financial side, as you hint, I would argue that the peg stymies meaningful financial reform, and thus retards the emergence of a world class financial system. credit controls, administrative caps, deposit floors and lending caps and the like are all become more not less entrenched — as if the use of non-market sterilization techniques.
On the other hand, no one really knows what a “world class Chinese financial system” looks like. The current US financial system was developed over time through a lot of trial and error, and I doubt anyone in 1970 would have had any idea that the US system would look like it does. (In particular, much of the current system depends on a crucial discovery that wasn’t made until public 1973, and in 1970, apparently only one person in the world knew about this, and he was busy beating the Las Vegas tables at blackjack).
If you had gone to the US in 1970, you’d be in the world of administrative set interest rates which were kept low to provide cheap loans for people to buy houses, in part of one of the most extensive and successful bits of social engineering the world has seen. The path from that system to the one that we have is one of accident and trial and error.
Successful complex systems are not planned, they evolve, and the fact that the Chinese financial system might be evolving into something that is really different than the US financial system, isn’t a reason by itself to say that those decisions are unwise.
‘Chinese’ vs. ‘US’ financial system - one possible concern being that both end up taking on each others’ worst characteristics - and while they’re busy with that, how Europe et al. evolve in the interim.
http://www.businessweek.com/investor/content/aug2007/pi2007088_450016_page_2.htm
Among the most prominent is Allan Meltzer, a Carnegie-Mellon University monetary economist who is writing a history of the Fed. “The people on Wall Street are making a lot of noise for a Fed bailout because they don’t like to lose money, and we can all understand that,” he says. “But…it would be a huge mistake to change monetary policy to rescue a bunch of people who made stupid mistakes.” In fact, argues Meltzer, losses by speculators could clean out the financial markets and make them healthier. “Capitalism without failure is like religion without sin,” Meltzer says. “It doesn’t work.”
“I am wondering to what degree the US could - in a situation where selling US bonds was used strategically against it by some sovereign entities - selectively default on bonds held by the Sovereign in question.”
nobody wants mutual destruction. you could of course declare war - sequester enemy assets - and then declare victory. it would all be over in a day. but nobody wants that. all trust would be lost. so the threats are made to help define where the line in the sand between financial peace and financial war actually lies.
i don’t fear the big chinese actor - we all agree that china would shoot itself in the pocket book if it started selling the dollar. big players have to buy to hold. but markets move when numerous little guys decide to play safe and leave the party. ( big guys only get stuck in the swing doors.) so it is the little guys and the anonymous guys that you need to fear.
i think we have reached a turning point. it is not capitalism v. communism. it is not big guys v. little guys. it is to do with credit . . .
the ponzidollars shovelled out to people who would barely qualify for a mortgage in ‘normal’ times are symptomatic of a peak in easy money policies. 100 per cent mortgage ? ( same game here in ireland. ) where do you go after 100 per cent ? 110 per cent ? the tide has to turn against the borrowers and in favour of the savers. it’s borrowers v. savers.
more free money is not the cure - and the european central bank pumping out money is like distributing free laxatives to tackle an outbreak of dysentry.
Can someone explain this China situation to me in simplistic terms? I have a friend in banking who, whenever I ask him about China and the amount of US currency they hold, he laughs and says “it’s no big deal, it can never hurt us because China will have to spend those dollars here in the US…and besides the Fed won’t allow them to cash all those bonds in at once. It’s useless and their threats are useless.”
I showed him the link to this article and he wrote me back:
“China can’t lose
money. They take loans out against those bonds and
grow their economy. The cost of the bond is paid back
in a few years as long as their GDP grows, and thus
the cash base grows including the loans. They don’t
care to ever cash in those bonds, they’ve made back
the money years before. Stop reading these stupid blogs.”
And I get scared bc I wonder if everyone in the industry thinks like that and it makes no sense to me.
From Peter Schiff,
http://www.europac.net/newspop.asp?id=9538&from=home
Amid all the recent hoopla about defective Chinese exports, America has proved that when it comes to flooding the world with shoddy merchandise, nobody beats the good old USA. Sporting higher yields than Treasury bonds, investment grade ratings from reputable agencies, and juicy commissions for the investment banks that packaged them, these structured mortgage bonds have quickly become America’s greatest export.
This week, several of Wall Street’s best foreign customers announced staggering losses on the American mortgaged backed securities they had been sold. The fundamental issue underlying these losses is that Americans borrowed more money than they can afford to repay. As initially low teaser rates expire and mortgage defaults increase, foreign lenders are discovering that the residential properties that collateralize the mortgage bonds are not worth anywhere near the loan amounts.
As more of our nation’s creditors finally realize that they have been duped, the credit well fueling American consumption will run dry. Foreign lenders will simply refuse to accept our IOU’s as payment for their merchandise. Lacking in savings and productive capacity, we will be forced to accept dramatic reductions in our standard of living as a result.
actually i have read some of grabbe ;P i think he had jim bell’s ‘assassination politics’ on his site and was semi-intrigued, esp w/ his http://en.wikipedia.org/wiki/Digital_Monetary_Trust which was right out of stephenson’s cryptonomicon; so after establishing my own libertarian (i’m not) nutcase bonafides, i still don’t see why you think a commodity reserve currency (among others) is inherently unworkable…
what about just commodity reserves, essentially a stabilization fund? (or local/community currencies? corporate scrip?) would you agree that if it instills confidence and enough people use it (isn’t outlawed) then it’s viable? or does only gov’t (with a ‘legitimate’ monopoly on violence within its borders) have the ability?
like i remember IBM was trying to develop computing as a ‘utility’ (aka ‘grid computing’) as a business model, but in order to do that they had to have a measure for a unit of computation (i think they called it a ‘util’ or ‘computon’ or something) so they could charge rates.
it didn’t work, but the point is that monetisation of some sort of a ‘commodity’ resource is a lot like securitisation by making something fungible (e.g. all AAA has the same risk — bad example, but anyway…) and therefore tradeable, you get a ‘currency’… so why not have piano-lesson backed currencies or whatever?
if people agree on it, then it should be valid in my book as a uniform system of measurement. i guess it depends on what you’d consider ‘uniform’ then, which is why you have standard-setting bodies…
“The idea of money as a source of social memory was also crucial for John Locke who figures prominently in our story as the philosopher who inaugurated the modern age of democratic revolutions. Locke was obsessed with money’s role both in establishing a progressive social order and in subverting it as its criminal antithesis. Indeed he believed that money launched humanity from the state of nature onto the road to civil government. As long as men’s possessions were limited to perishable products, the scope for property was restricted. Money, by offering a durable store of value convertible against all useful things, unleashed the potential for property accumulation and for the intergenerational transmission of inequality. For Locke then, money was indispensable to that development of cultural memory on which civilisation depends.” http://www.thememorybank.co.uk/book/chapter-1
Re — Guest on 2007-08-10 13:49:17
I agree with your friend in that the few trillion USD they pile up is not the main thing for China. They can loose all of it, no problem. The important thing for them is that the process which produces these big trillions as a byproduct, transforms China into an economic superpower in a very short time. If they get to this position in say 20-30 years, why should they care about a few trillion USD.
gillies — i actually disagree with what we all agree on (that china shoots itself in the pocket book if it starts to sell dollars) … since i argued (note the post above) that china shoots itself in the pocketbook every time it adds a dollar to its portfolio. sure, ending the status quo (and the status quo is dollar buying, not holding on to china’s existing $) means taking losses — but china would face far smaller financial losses by changing policy now than by changing policy later, when it has far more dollars. where china hurts is on the export side.
of course, everybody may be right and i may be wrong, but i have a lot of convinction on this one: to avoid losses now, china has to add to its future losses.
curious guest: China may have hedged v move sin eur/$ — i.e. it coudl have swappped some of on balance sheet $ for euros through an off balance sheet transaction. my guess tho is that china couldn’t do this in a big way without the market getting wind of it, and if it did it in a big way, it would move the eur/$ market (someone else has to take the $ for China to get rid of it). macroman is alas on vacation, but he would have a better sense of this than me.
the main risk that china is taking tho is not the risk that the $ tanks v the eur, but rather that the RMB appreciates against both the EUR and the USD. and china cannot hedge that risk away — no one else wants to hold $ when they can hold RMB, which is why the PBoC is building up its dollars in the first place. basically, that risk is an unhedgeable risk — and it is a risk the pboc has to take so long as it wants to keep the rmb stable v the $ in the face of market pressure for appreciation.
guest with a banker friend who doesn’t like stupid blogs …
well, on this issue at least, i think i am reasonably credible — i used to work at the US treasury, i testify before congressional commitees, and the like. I have my point of view, of course, but i hope I rise above the average level of a “Stupid blog” from time to time. Your banker friend is right in the sense that china’s dollars ultimately have to be spent on us goods (or traded for something else), tho i guess they also coudl be sold to domestic chinese investors who want to buy US assets (if such demand materialized; right now, chinese savers prefer to keep their funds at home). He also is right that the growth in china’s dollar reserves is fueling rapid money and lending growth in china, tho china could achieve the same thing by “monetizing” domestic Chinese bonds without taking on the $ risk it now is taking on. Your banker friend should understand that — basically, a central bank can print cash against either domestic bonds (what the US does) or foreign assets (what china does) and if you print cash against assets denominated in your own currency, you have less currency risk. I think your banker friend misses one key point though: to keep the game going, china has to not just hold on to its existing dollars, but to buy every more dollars to provide the US with the ongoing financing needed to cover the uninted states cash flow deficit. the scale of financing that china is providing to the us is rising strongly over time as well — so the real question is whether china will continue to do so indefinately, and then what happens when china becomes a bit less willing to make up for a shortfall in market financing for the us deficit. part of the answer is that china itself will take losses. but part of the answer is that the us economy also would need to adjust — i personally think we would be better off if that adjustment started sooner not later.
in any case, the views of your banker friend are fairly common. my view is more of a minority view. but it isn’t that far — i suspect — from the views of Dr. Summers, so it isn’t an entirely crazy minority view. you might want to print out Summers’ per jackobsen lecture (i am sure i misspelled the lecture name)and give it to your banker friend — it discusses these very issues (it is the second link in the blog).
“China will have to spend those dollars here in the US”
on what? is $1.3 trillion enough to buy hank paulson?
Re “selective default” Assume that various declarations and political tensions made it clear that an overt and unprecedented financial attack on the US by a sovereign state was underway, I would hope that we would have options other than the nuclear option of selectively defaulting on them. For example, when North Korea got into our cross hairs with massive counterfeiting we told them it was an attack on our currency and then we really roughed them up, shut them out of the global financial system, and before letting them back in we reminded them that we could do it again - in spades - at any time. Obviously this kind of confrontation with a major state is way out there. It’s impossible to imagine China being that stupid, but a newly belligerent thuggish Russia? Anyway, a sovereign-sourced attack on the US currency, particularly if out of open enmity or a raw power play, would have to be answered somehow, either overtly or through quiet threats, as a national security issue. Surely there are other financial retaliatory tools at our disposal. If successful, it might even reassure dollar holders in the long run.
While Chinese official dollar reserves of $1.2 trillion exceed the $880 billion Japan reported, when the vast US dollar holdings of Japan’s private sector banks and companies are added to official reserves, it becomes clear that Japan and not China continues to play the central role it has for 25 years now in supporting the global value of the dollar and by extension, US global hegemony. So why aren’t you asking the real question, whether Japan will continue to do so indefinitely, and then what happens when Japan becomes a bit less willing to make up for a shortfall in market financing for the US deficit?
Twofish,
maybe in theory selective default doesn’t make any sense, but in practice Russia came out pretty well from doing exactly that. For those less familiar with Russia: in 98 Russia defaulted on most domestic debt (think GKOs), but kept honouring some other domestic debt, as well as its Eurobonds. Stupid?
From the Russian point of view this had the advantage of being able to favour domestic investors over foreign ones, and honouring Eurobonds arguably allowed them to get their respectability back quicker than they otherwise could have.
I know reputation is generally seen as binary (you destroy it or not) - and believed in this when I was young. After the Russian example, I am however not that sure about this any more.
Discussion of commodity currencies is always the best way to bring the moldbug out of his hole.
First, there is only one conceivable commodity that the real world of 2007 could adopt as a currency. That currency is mold. Baskets of metals or other commodities (as Hayek proposed in his “Denationalization Of Money”) are an extremely bad idea.
The reason is that, compared to a comparable commodity which is not used as currency, any commodity used as money must be tremendously overvalued. This is a feature, not a bug. At present we use slips of engraved paper as money, and slips of blank paper on the commode. The relationship between engraved paper and blank paper is precisely analogous to the analogy between a monetized and an unmonetized metal, even a precious metal (eg: mold and platinum).
Converting the global financial system from paper to a commodity currency, a change I (like Benn Steil) view as inevitable, will disrupt the real economy no matter how it is done. The goal of any plan for restoring commodity money must be to minimize, not eliminate, disruption, and to make its effects as politically favorable as possible to the governments which would have to enact the plan.
(The reason governments should be interested in a controlled restoration of commodity money is simple. If it happens as Steil suggests, privately, the effects will be extremely disruptive. Private restoration of a commodity monetary system is equivalent to the phenomenon generally known as “hyperinflation.” While this is a proven and effective remedy, it is not a pleasant one.)
Mold is the least disruptive choice because the ratio between the mold price at present, and the mold price in a 100%-backed hard-money mold economy, is lower than for any other good. Also, the microeconomics of the mold extraction business, and the large existing stock of mold, suggest that the effect of remonetization on mold supply will be relatively restrained. This is certainly not the case for, say, copper, or even the other precious metals.
The algorithm for restoring the mold standard is extremely simple. The problem consists entirely of setting the new exchange rate between fiat and mold. To minimize disruption, all fiat currencies worldwide should be pegged permanently to mold in one step - a flag day transition - preserving existing cross rates, and assuming 100% backing. The result will be a world in which all currencies are defined, as the dollar once was, as a specified weight of mold, and there is no fractional-reserve banking, maturity mismatching or other Ponzi finance.
For a zero-disruption solution, the value (in dollars) of everyone’s bank account, portfolio, hedge fund, ETF, or Krugerrand stash would not change at all. Everyone’s monthly statement would look very similar to the previous statement, except that all holdings and securities prices would be denominated in 100%-backed mold. Effectively, Fort Knox would be converted to a digital gold currency such as James Turk’s GoldMoney. Maturity demand would match maturity supply, so that the financial system would no longer be dependent on “liquidity” (CB intervention to alter the shape of the natural yield curve).
Zero disruption is clearly impossible. Minimizing disruption, therefore, must be the goal. And politics being what it is, “inflation” is preferable to “deflation” - if anyone’s portfolio changes across the flag day, it should go up rather than down.
First, any controlled remonetization must start with a substantial in-kind tax on existing holders of mold. Like any tax, this tax will have a Laffer curve, whose shape in this case is defined by the large quantity of mold outside financial supervision. The tax should aim at the Laffer maximum, which is almost certainly over 50%. Of course, in a remonetization event, even a tax of this level will leave moldbugs with an enormous windfall profit. Just think of it as our consulting fee.
The proceeds of this tax, plus official mold reserves, are your denominator D. The volume of fiat currency in existence is your numerator N. The new mold price is N/D.
All of the above is straightforward. But the reason the nettle is difficult to grasp is that, without extremely drastic measures, it is impossible to compute N.
The trouble is that the volume of fiat in existence is not M0 - the number of printed bills. If you simply used M0 as N, you would get a recession that made the sack of Rome look like a block party. Bodies would be burning in the streets, and no one would have time to collect them. They would all be too busy staring at their bank and brokerage statements, from which a couple of zeros had disappeared quite inexplicably.
Using M0 as N is equivalent to simply closing down all central banks immediately, eliminating the power to print new money completely and permanently. It is equivalent to the Fed, ECB and other CBs setting their discount rate to infinity, or some effectively equivalent figure (200%, perhaps), and announcing that neither the FDIC, nor the agencies, nor any other entity public or private, is or will ever be eligible for any sort of bailout.
The correct value of N is whatever fraction of the current market price of all financial assets is a consequence of the CBs’ power to create money. To calculate N, therefore, we could take the value of all assets today, perform our little sack-of-Rome experiment in hyperdeflation, find the ratio between the two, and multiply by M0. Unfortunately, this would be a case of destroying the village in order to save it.
One way to improve on this procedure, therefore, is to acknowledge that a financial market in a fiat-currency monetary system is not and cannot be a “free” market. Therefore there is a much simpler way to calculate N. Simply nationalize all financial assets at their present market price. (Dodgy assets, such as “mark-to-model” toxic waste, should not be eligible for this program and will have to be handled specially.)
I am not suggesting, of course, that a transition to sound money can only be achieved as part of a transition to Communism. Nationalization of financial assets is a temporary measure only. Once the monetary system is reconstructed and stabilized, these securities can and should be sold. This generates more money for the state, giving it a cushion so that it can transition gently out of its present bad habit of permanent deficit financing. The result is, again, inflationary, but not hyperinflationary, and it seems no more inflationary than the present unsustainable system.
The main question is whether such a flag-day nationalization should include all publicly-traded equities, or whether it should be limited to bonds, derivatives, etc. Since equities are valued by earnings, since present valuations in most markets do not appear ridiculous when compared to earnings, since we are minimizing financial disruption and confining it to the inflationary upside, and since thus the change to revenues and balance sheets of public corporations should be similarly reduced and kept to the upside, it’s possible that equity trading could simply continue without even closing the markets.
However, tinkering with this kind of distinction seems risky. The simplest and safest approach strikes me as a complete nationalization of the entire financial industry, calculating N as simply the sum of all individual portfolios, and effectively netting out all relationships between financial actors.
Again, if the value of every individual’s account is the same after the flag day as it was before the flag day, unless of course that account contained mold (it is imprudent to reward people too much for holding mold outside the financial system), the effect of the flag day on their economic behavior will not disrupt existing patterns of trade and exchange. For example, it will allow normal repayment of existing debts, neither effectively cancelling them through hyperinflation, or rendering them unpayable through hyperdeflation.
In my opinion, the main obstacle to this solution is that it involves the admission that the paper financial system of the Progressive and postwar eras was, as most 19th-century economists would have agreed, fundamentally criminal. Therefore it’s essential that any such flag day include an explicit amnesty for anyone whose actions were legal under the fiat system - even though in a modern fully-backed monetary system, barring an extremely libertarian approach to financial regulation, maturity mismatching would be illegal. Professor Bernanke would need a new job and perhaps a new profession, but he wouldn’t find himself making license plates.
bsetser: i personally think we would be better off if that adjustment started sooner not later.
I’m not so sure for two reasons. First the longer one waits, the bigger both the Chinese and American economies are, and the easier the adjustment. Second, the longer one waits, the more one learns about the land mines buried as you try to change an economy.
Also from the point of view of political economic, being in the middle of a major war is rarely a good time to invoke tight fiscal policies. It might make sense not to adjust until the long term situation in Iraq becomes clearer, since finance is one of the aspects of Iraq that no one talks about, but should.
As far as Larry Summers. When I heard him talk, he stated that his position is that China has to move toward a floating currency (because over time capital controls would be less effective and so rates have to float if China wants an independent monetary policy.)
He said that he had intentionally no opinion as to timing, pacing, and sequence. The main reason that he said that he had no opinion on this, was that when he was Secretary of the Treasury, people would always come up with well-meaning ideas on how to run the US economy that were totally impractical for one political or economic reason or another, and that the Chinese leadership are far more knowledgeable about their political and economic constraints than any outsider could be.
dc — china now has 1.3 t in reserevs, not 1.2 — and at least $100b with the state banks. its current account surplus is bigger than japan’s and total foreign asset accumulation of china’s state exceeds total foreign asset accumulative by japanese investors. ergo a focus on china is entirely appropriate — especially since theis blog focused more on official flows than private flows.
2fish — the cost of adjustment are not constant either — in my view they are rising even faster …
and yes Summers has been leery of pushing too publicly on China to change more rapidly.
To DC: It would seem to me that a rising China would make Japan even more likely to do what Washington wants them to.
USGrant: it clear that an overt and unprecedented financial attack on the US by a sovereign state was underway, I would hope that we would have options other than the nuclear option of selectively defaulting on them.
Sticks and stones may break my bones, but financial threats can merely bankrupt me. The amount of damage that an outside power could do by financial means is extensive but at the same time, you haven’t destroyed any real infrastructure, and if the US cares enough about something that being