The Baseline Scenario

“World Bank Chief Economist Justin Yifu Lin staked out a strong position against forcing China to let its currency appreciate as a way to rebalance the world economy.

“’Currency appreciation in China won’t help this imbalance and can deter the global recovery,’ he said in a lecture Monday at Hong Kong University.

“In an interview after the lecture, he said other countries shouldn’t intervene to keep their currencies cheap to boost their export sectors, calling it the ‘equivalent of protectionism.’”

You can read the rest at Real Time Economics. No, it doesn’t make more sense — except possibly as an expression of China’s policy.

By James Kwak

President Obama leaves next week for a high profile trip that includes meetings with other “Asia-Pacific” countries (in the APEC forum) and a visit to China.  The President has had considerable diplomatic success on the economic front to date, including at the G20 summit in April and – to a lesser degree – at the follow-up September summit in Pittsburgh.

But the issues facing him now in Asia are particularly difficult, primarily because of China’s exchange rate policy.  China essentially pegs its currency (known as the yuan or renminbi) against the US dollar, which means that it rises and – most recently – falls in tandem with the greenback.

Many countries operate de facto pegs of this nature, but China is problematic for three reasons: it is a large economy (10 percent of world GDP, if we adjust for purchasing power), it runs a big current account surplus (exporting more to the world than it buys from the world, in the range of 6-12 percent of the Chinese economy), and it consistently has a bilateral surplus with the US that is galling to many on both sides of the aisle on Capitol Hill (and their constituents). Read the rest of this entry »

We’ve been at first amused but more recently alarmed at how “global imbalances” are becoming many people’s preferred explanation of the financial crisis. At first you could brush it off this way: “global imbalances (read: ‘blame China’) . . .” But this explanation is going mainstream, not least because it is always more convenient for policymakers and bad actors to blame someone far away. For example, Dealbook (New York Times) kicked off a roundtable on the causes of the financial crisis this way:

“There is a conventional view developing on the financial crisis. The Federal Reserve’s policy of historically low interest rates spurred a worldwide search for higher risk and return. Concurrently, the entrenched United States trade imbalance led to a huge transfer of dollar wealth to Asian and commodity-based countries. The unwillingness of Asian economies, particularly China, to stimulate their own domestic consumption led these countries to reinvest the proceeds into the United States. This further contributed to lower American interest rates and further fueled the search for return.”

(Mortgage securitization gets mentioned, but only in the fourth paragraph!)

Simon and I took this on in our Washington Post online column this week, but I thought it was interesting enough to repost here in full, below.

***

The time is here for our nation to actually do something about the recent financial crisis — that is, do something to prevent it from happening again. But instead, many people are finding it easier to pass the buck than to, say, regulate the financial sector effectively.

The recent Group of 20 conference in Pittsburgh was replete with talk about “global imbalances,” which means — in the spirit of the “South Park” movie — “blame China!”

Read the rest of this entry »

This post was written by StatsGuy, a regular commenter here and very occasional guest contributor. We asked him to expand on the ideas he put forward in this comment on the relationships between monetary policy, international capital flows, and bank capital requirements.

Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.

Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)

Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines).  How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)

Read the rest of this entry »

The usual concern about the US-China balance of economic and political power is couched in terms of our relative international payments positions.  We’ve run a large current account deficit in recent years (imports above exports); they still have – by some measures – the largest current account surplus (exports above imports) even seen in a major country.  They accumulate foreign assets, i.e., claims on other countries, such as the US.  We issue a great deal of debt that is bought by foreigners, including China.

There are some legitimate concerns in this framing of the problem - no country can increase its net foreign debt (relative to GDP) indefinitely without facing consequences.  And the Obama administration, ever since the Geithner-Clinton flipflop on China’s exchange rate policy early in 2009, seems quite captivated by this way of thinking: Will they buy our debt? Can we control our budget deficit? What happens if China dumps its dollars?.

The reason real to worry about China, however, has very little to do with external balances, China’s dollar holdings, or even capital flows.  It’s about productivity and rent-seeking. Read the rest of this entry »

On Monday and Tuesday of this week, Treasury Secretary Geithner – and Secretary of State Clinton - meet with a high-level Chinese delegation.  (Could someone please update the Treasury’s schedule of events? At 7am on Monday it still shows last week’s agenda; update, 9am, this is now fixed – thanks).

According to official previews (i.e., the apparent contents of background briefings given to wire services), the economic topics are China’s concerns about the value of the dollar (i.e., their investments in the U.S.) and the amount of debt that the U.S. will issue this year.

This is absurd. Read the rest of this entry »

On his China visit, Secretary Geithner is immediately on the defensive.  The language he is using on the Chinese policy of exchange rate undervaluation-through-intervention is the mildest available.  And the commitment he is making, in terms of bringing down the US deficit – which we all favor – is an extraordinary thing to put numbers on in a foreign capital.  Such commitments are of course unenforceable, but still the wording indicates – and is understood by China – great US weakness.

Not surprisingly, China seems likely to push for more.  Their main idea is that some part of their US dollar holdings be transfered to a claim on the International Monetary Fund, which would shift it from being in dollars to being in Special Drawing Rights – and therefore a claim against (a) the IMF’s whole membership, and (b) presumably, the IMF’s gold reserves.

This is a bad idea. Read the rest of this entry »

At his confirmation hearing in January, Tim Geithner nailed the China Question.  China prevents its exchange rate from appreciating through intervention (buying foreign currency), and this allows it to sustain a large current account surplus.  Geithner said, as plainly as you can expect from a senior official: this is not in accordance with international rules and should stop.

Not only is this sensible economics and correct on the rules, it is also good politics.  If you want to head off the considerable inclination towards protectionism in Congress, it would help greatly for the Chinese renminbi to rise in value (e.g., review the discussion at this House hearing).

But almost as soon as Geithner spoke on this issue, there was slippage.  By late February, Hillary Clinton was asking the Chinese nicely to continue holding US Treasury securities and, it now seems, punting the exchange rate issue.  Above all else, China wants to be left alone on the renminbi – variously arguing that any appreciation would jeopardize jobs, derail growth, and plunge the country into chaos.

So what should we expect from Geithner’s upcoming China trip? Read the rest of this entry »

I’m warming up for a longish Beginners-style article on government debt, which will come out next week or so. In the meantime, the New York Times has an article today about China’s diminishing demand for U.S. dollar-denominated debt. Theoretically this could make it harder for the U.S. to borrow money and thereby push up the interest rates on our debt (now at extremely low levels).

China’s voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying American bonds will reduce this dampening effect.

However, the article doesn’t mention one compensating factor. The fall in China’s buildup of its foreign currency reserves is linked to the rise in the U.S. savings rate, which is projected to rise to as much as 6-10% (it was over 10% in the 1980s). Some of that new savings will go to pay down debt, but a lot will go into savings accounts, CDs, money market funds, and mutual funds – which means that depresses interest rates across the board. On the back of the envelope, 6% of personal income is about $600 billion a year in new domestic savings to compensate for reduced overseas investment. Whether this will be enough to compensate entirely I don’t know. But if we were all one global economy in the boom, we’re still one global economy in the bust.

We’ve gotten some comments to the effect that, for all the discussion of the financial crisis and the various bailouts, we haven’t looked hard at the underlying causes of the financial crisis and accompanying recession. The problem, as I think I’ve hinted at various times, is that any macroeconomic event of this magnitude is overdetermined, on two dimensions. First, there are just too many factors at play to identify which are the most important: in this case, we have lax underwriting, lax bond rating, skewed incentives in the financial sector, under-saving in the U.S., over-saving in other parts of the world, insufficient regulation, and so on. How many of these did it take to create the crisis? There is no good way of knowing, because the sample size (one, maybe two if you add the Great Depression) is just not big enough. Second, there is still the conceptual problem of identfying the proximate cause(s). To simplify for a moment, we had high leverage which made a liquidity crisis possible, and then we had the downturn in subprime that made it plausible, and then we had the Lehman bankruptcy that made it a reality. Which of these is the cause? Leverage, subprime, or Lehman?

In any case, we’re not going to resolve these issues. But I want to start an occasional series of posts looking at one of the root causes at a time.

Today’s topic was inspired by this week’s meetings between U.S.-China meeting in Beijing, where, according to the FT, “the US was lectured about its economic fragilities.”

Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” he said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

Read the rest of this entry »

So, the global economy is falling apart, but not in the way people expected. Under the de facto arrangement sometimes known as “Bretton Woods II,” emerging market countries pegged (officially or unofficially) their currencies to developed world currencies at artificially low rates, having the effect of promoting exports and discouraging consumption by emerging market countries and promoting consumption and discouraging exports in developed countries. Of course, the classic example of this was China and the U.S. The U.S. trade deficit and Chinese trade surplus created a surplus of dollars in China, which were invested in U.S. Treasuries and agency bonds, keeping interest rates low and indirectly financing the U.S. housing bubble and consumption binge of the last decade (and, therefore, growth in Chinese exports).

The general fear was that U.S. indebtedness would lead China to diversify away from U.S. assets, causing the dollar to fall and U.S. interest rates to rise, hurting the U.S. economy and making it harder to finance the national debt. This may yet happen someday. But instead of demand for Treasuries collapsing, it’s been demand for every other type of asset that has fallen. Treasury yields have collapsed and the dollar has appreciated about 20%. Still, despite this increased purchasing power, the fall in U.S. (and global) consumption is having a severe impact on growth of the Chinese economy. Even though the Chinese government has signaled that it will do everything in its power to keep growth above 8% per year (down from 11-12% in the past few years), the slowdown has severely constrained the ability of the urban manufacturing sector to absorb internal migration from the countryside, and there are signs of a reverse migration that is aggravating the problem of rural poverty in China. Although China may seem to have all the cards – high economic growth, large foreign currency reserves – it could yet turn out to be a major loser of the global economic crisis.

This is of course just a brief introduction. For more I recommend Brad Setser, among others: some of his posts are here, here, and here.

Other countries can only drool with envy. China today announced a $586 billion stimulus package – that’s 17% of 2007 GDP. Spread through the end of 2010, it’s still more than 7% of GDP per year. By comparison, the US stimulus package earlier this year was just over 1% of GDP, and after causing a small uptick in spending in Q2 it vanished into the sea of bad news; our recent proposal was for 3% of GDP, and that was at the higher end of the range.

Of course, the stakes for China are very high. GDP growth ranged between 11 and 12% in 2006 and 2007, but the IMF recently cut its estimate for 2009 to 8.5% (down from the 9.3% estimate just a month ago), and according to the New York Times article the annualized rate for this quarter could be as low as 5.8%. While these are growth rates that the developed world hasn’t seen for decades, the huge population migration from countryside to city requires high growth simply to keep unemployment in check. So the Chinese government brought out the heavy economic artillery.

The current crisis has proven, if it needed any proof, that even China is susceptible to the fortunes of the global economy. If it can lead to greater participation by China in the global financial system, including institutions like the IMF, that would be one positive outcome.

OK, that may be a bit of a stretch. But there’s little doubt that the global recession will take its toll on China’s double-digit growth rates.

One (emailed) response to our recent Washington Post op-ed criticized us for overlooking the role of China (although we did discuss China in the following Forbes article). In particular, the reader said, “it is my opinion that China holds all of the cards and I believe they will likely play some of them early in the next U.S. administration” – this because of China’s role in financing the U.S. deficits by investing in Treasuries. This may be true in the long run, although of course China cannot try to damage the U.S. economy without also crippling its own export-dependent economy. More immediately, though, China is facing an old-fashioned slowdown of its own.

All Things Considered did a story this past week on the impact of the global slowdown on Chinese exporters. One figure jumped out at me: 80% of the toy factories in Guangdong province have closed.

Also, the Baltic Dry Index, a measure of bulk cargo shipping costs and hence of global demand for heavy stuff (largely commodities) has fallen off a cliff this year (see the second chart in that post) – one reason why the Shanghai Composite Index is down more than 60% this year.

China is a place I won’t claim to understand. But as we all know, the Chinese government relies on an unsteady equilibrium in which it uses economic growth to legitimize the political system and convince the growing middle classes not to question the political order. Tocqueville’s observation (which I alluded to in my previous post) about the tendency of political strife to arise not out of prolonged abject misery, but when increasing expectations are dashed, could turn out to be particularly appropriate for China.

Update: Thanks to Randy for his comment (below). I fixed the error regarding the Baltic Dry Index.

Update: The Economist has a post with almost the same title as this post – but no question mark.