I was surprised by how conservative China was in the immediate aftermath of the crisis.

TO BE NOTED: From Follow The Money:

"Creditors generally do like to lend in their own currency …

Posted on Tuesday, March 31st, 2009

By bsetser

China may not be an exception after all.

A creditor than lends in its own currency doesn’t have to worry all that much about the risk that it its lending is denominated in a currency that will depreciate. The borrower assumes the risk its currency will depreciate against the currency of its creditor as a condition for getting financing.

That is good for the creditor, and not so good for the borrower.

Back its days as a large creditor, the US (both the US government and private US creditors) generally lent in dollars. That meant that if a Latin currency depreciated against the dollar, the borrower had to find the dollars it needed to repay the US – or default and accept the consequences. Latin countries couldn’t allow their currencies to fall against the dollar and, in the process, reduce the real value of their foreign debts.

China is now a major creditor. But its foreign assets though are denominated in dollars, euros and yen – not RMB. That means that if the dollar depreciates against the RMB, it is China’s problem, not the United States’ problem. The amount of dollars the US has to pay China doesn’t change. But the amount of RMB that China gets for each dollar will fall

China’s willingness to take on this risk in some sense part was a core part of the Bretton Woods 2 system where reserve growth in emerging countries like China financed the United States external deficit. Had the United States external debt not been denominated in dollars, Dr. Roubini and I would have been even more worried by the size of the United States external debt than we were back in 2004. If United States debt structure hadn’t been as favorable, the dollar’s slide from 2002 on would have generated much, much larger problems.

China seems to have woken up, belatedly, to the fact that lending to the United States – or any other country – in its borrowers currency is risky. It probably should have started to worry some time ago, before it had $1.6 trillion or so of dollar-denominated claims. As the FT noted in a recent leader, “The People’s Republic has, however, over-exposed itself to the US, piling up dollar-denominated securities.” China is currently struggling with a problem that is very much of its own making.

China could, in theory, address this problem by ending its accumulation of dollar and euro and yen denominated reserves and instead making RMB denominated loans to the rest of the world.

Internationalizing the RMB poses two problems though.

First, most debtors, including the US, currently do not issue any RMB denominated debt – and I would strongly argue that they shouldn’t start. The countries able to borrow in their own currency at low rates should do so. And countries that have to pay more to borrow to borrow in their own currency also should generally do so, to avoid dangerous currency mismatches. Brazil has benefited immensely in the recent crisis from the fact that most of its debt is now denominated in real.

Second, expanding the “international use” of the RMB is rather hard when China doesn’t want foreign investors to hold RMB denominated assets. If say Argentina had RMB denominated debts, it also might want to hold some RMB denominated reserves as well.

And that would mean allowing foreigners to buy some of the RMB debt that China’s government issues and to hold it as part of there reserves.

That is the rub. Remember, buying RMB debt is also a way of speculating on the RMB.

If China made the RMB fully convertible, anyone could buy long-term RMB denominated debt and benefit if the RMB rose over time. That isn’t something China that has wanted. Remember all the complaints about speculative capital inflows a year ago?

Still, China’s willingness to provide RMB credit to Argentina suggests that China is beginning to recalibrate its definition of its interests.

It is further evidence that China is defining its interest as a creditor – not just as an exporter willing to accept losses on the “vendor financing” it supplies on subsidized terms to those it hopes to encourage to buy its goods.

I was surprised by how conservative China was in the immediate aftermath of the crisis.

It seemed to be concerned almost exclusively with the need to minimize the credit risk in its reserve portfolio. That meant turning down requests from countries like Pakistan for bilateral financing – as well as selling Agencies and buying Treasuries. Now it seems that China has concluded that it has reduced the credit risk in its reserve portfolio to an acceptable level and is turning its eye toward reducing its currency risk.

That though may be a tougher nut to crack.

Perhaps the state council was spooked by a memo the PBoC sent up the food chain laying out all of the risks that remained in China’s portfolio. If the rumors that China’s leaders were surprised to discover the extent of their exposure to Fanny and Freddie are true, the PBoC has every incentive now to make sure that China’s top leaders aren’t surprised by any future currency losses on China’s reserves.

But the state council has also historically been response to the concerns of China’s exporters – and the core tension between China’s interest as an exporter and its interest as a creditor remains.

Moreover, I am not exactly sure it would be a good thing for China to replace a lot of dollar lending to the world with a lot of RMB lending to the world. China would take on less currency risk to be sure, but all the problems created by China’s large surplus would remain. Actually, they would get worse — as more risk would be in the hands of the world’s big borrowers.

The FT leader again: “[China] must not just replace its mountain of dollar assets with heaps of other currencies.” Exactly right."

"Hot money has to go somewhere and hot money outflows from China could go into the dollar"

Brad Setser:

"China hasn’t (yet) lost its appetite for US Treasuries …

Posted on Thursday, January 8th, 2009

By bsetser

Agencies, yes. But not Treasuries.

Keith Bradsher of the New York Times, citing Ben Simpfendorfer of RBS, argues that China’s government is likely to reduce its purchases of US debt.

“All the key drivers of China’s Treasury purchases are disappearing — there’s a waning appetite for dollars and a waning appetite for Treasuries, and that complicates the outlook for interest rates,” said Ben Simpfendorfer, an economist in the Hong Kong office of the Royal Bank of Scotland.

In some sense China’s purchases of US debt has to fall from its current level, as the current level of purchases is unsustainable in a context where China’s reserve growth seems to have slowed. The TIC data show a $44.4b increase in China’s US holdings in September and a $67.5b increase in October, with nearly all the increase coming from the rise in China’s short-term Treasury holdings.

That said, the available data from US suggests that China has yet to lose its appetite for either dollars or Treasuries, despite all the talk coming out of China.( THEY ARE NOT EAGER TO CHANGE ANYTHING. )

We don’t have data for November or December, so the US data are by now a bit stale. But China’s $67.9b of purchases of Treasuries in October were exceptionally high ($43.5b in September isn’t shabby either). That level of Treasury purchases suggests, if anything, that China was shifting funds into dollars, as China’s recorded US purchases almost certainly exceeded China’s October reserve growth. I suspect that China wasn’t shifting into the dollar so much as holding more dollars in ways that register in the US data, so I would discount this data point a bit. Still, the raw October data doesn’t indicate a shift away from either the dollar or Treasuries. Rather the opposite.( THIS MAKES SENSE )

Over the last 12 months, China’s recorded US Treasury purchases have topped $190 billion — a record. Most of the rise has come in the past few months of data. The US survey of foreign portfolio investment has tended to revise China’s purchases of Treasuries up, so $190 billion should be considered a minimum.

The TIC data for November and December isn’t available. But I suspect that the $136b increase in Fed’s custodial holdings of Treasuries over the last two months provides some clues about the evolution of China’s portfolio. Central bank holdings of Treasuries at the Federal Reserve Bank of New York continue to rise rapidly. As of now, I would argue the available evidence suggests that China’s appetite for Treasuries has increased in q4 — largely because of a fall in its appetite for Agencies( FROM IMPLICIT TO EXPLICIT GUARANTEES ). Let’s see what the November and December TIC data show.

Looking ahead, China’s official purchases of Treasuries will be function of three things:

1) The pace of China’s reserve growth. That will be determined by the evolution of China’s trade surplus, FDI flows and hot money flows. The World Bank expects China’s current account surplus to rise in dollar terms in 2009( THAT'S WHAT CHINA WANTS ); I tend to agree. Oil will not average close to $100 a barrel in 09. The fall in commodity import prices will help to offset a (probably large) fall in exports. The fall in exports implies fewer imported components, and China’s domestic slowdown implies fewer imports too. But FDI inflows will slow and hot money flows clearly have reversed, so overall reserve growth (counting the increase in China’s hidden reserves) should slow.

2) The share of China’s reserves that are held in dollars. That is currently close to 70% best I can tell. I have no idea if China will want to continue to maintain that dollar share even as the US runs huge fiscal deficits. But now that China is pegging tightly to the dollar, I would guess that Europe would put a lot of pressure on China not to sell dollars for euros in a way that drives up the euro. That would be tantamount to driving the RMB down v the euro to support China’s exports to Europe. I consequently don’t expect a big change in the dollar share, but that is a huge assumption. ( CHINA DOESN'T WANT TO SELL DOLLARS )

3) The share of China’s dollar reserves that are invested in Treasuries. That share is currently rising, big time. At some point though China will have brought its Agency portfolio down to an acceptable level and start to worry about the size of its Treasury holdings. So I wouldn’t expect it to rise forever.( THIS MAKES SENSE )

Sum it all up and the pace of China’s Treasury purchases should fall from their recent monthly highs in 2009. But that is only because they currently are at such a high level. Even SAFE cannot sustain a close to $70b a month pace of Treasury purchases for all that long. Not unless it really plans to run its Agency portfolio down to zero. ( WE'LL SEE )

One last point: Hot money has to go somewhere and hot money outflows from China could go into the dollar( THAT'S WHERE THEY WANT IT TO GO ). If Chinese reserve growth is below China’s 2009 current account surplus, private Chinese investors will be building up their foreign assets. China’s government won’t necessarily be the only Chinese buyer of dollars. Or, for that matter, euros.

Data on China’s recorded long-term purchases are here, data on China’s short-term holdings are here)."

China, being a Saver/Export Country, will do everything to keep the Saver Country/Spender Country Symbiosis alive.

"the more the world’s biggest surplus country does to support its exports, the more frustrated the world’s deficit countries are likely to become …"

As I've been saying, I don't see the Saver/Export Countries giving up on the current arrangement easily or without a fight. From Brad Setser:

"As trade slows, China doesn’t rethink its growth strategy …

Posted on Friday, January 2nd, 2009

By bsetser

My title is a play on the New York Times’ online headline: “As Trade Slows, China Rethinks its Growth Strategy.” The print version of the Times carries a headline that more accurately reflects the content of Keith Bradsher’s story : “Juggernaut in Exports is Withering in China.”

Chinese exports were doing reasonably well in October but dipped in November and — if Korea’s December trade data offers any guide — will fall even more in December. Bradsher’s story documents the depth of the slowdown but doesn’t offer much evidence that China is “rethinking” its growth strategy. Bradsher reports:

“In the last two weeks, Chinese officials have announced a series of measures to help exporters. State banks are being directed to lend more to them, particularly to small and medium-size exporters. Government research funds are being set up. The head of the government of Hong Kong, Donald Tsang, plans to seek legislative approval by late January for the government to guarantee banks’ issuance of $12.9 billion worth of letters of credit for exports. Particularly noteworthy have been the Chinese government’s steps to help labor-intensive sectors like garment production, one of the industries China has been trying to move away from in an effort to climb the ladder of economic development with more skilled work that pays higher wages. But now China has become reluctant to yield the bottom rungs of the ladder to countries with even lower wages, like Vietnam, Indonesia and Bangladesh.

China has been restoring export tax rebates for its textile sector, for instance, which it had been phasing out. Municipal governments have also stopped raising the minimum wage, which doubled over the last two years in some cities, peaking at $146 a month in Shenzhen. “China will resort to tariff and trade policies to facilitate export of labor-intensive and core technology-supported industries,” Li Yizhong, the minister of industry and information technology, said at a conference on Dec. 19. “

Rather than trying to shift away from exports, the global slump seems to have prompted China to cling to its existing export-led growth strategy( TRUE ). China seems to be rethinking is its previous willingness to move out of low-end labor-intensive exports as higher-end export sectors expand. With jobs scarce, that no longer seems like a great idea. China also seems to be rethinking its exchange rate policy. Here too it seems to going back to the past. Over the past several months the RMB has been effectively repegged to the dollar — going up when the dollar went up (October) and going down when the dollar went down (December).( YES )

But the global environment is changing in ways that will make it harder for China to avoid a sharp downturn in its exports no matter what China does. And that isn’t just because China’s efforts to subsidize its exports and limit the RMB’s appreciation against the dollar may attract the ire of the US. Bradsher reports that Indonesia is keen to find ways to limit its imports from China that do not formally violate its WTO commitments ( HERE WE GO ).

In Indonesia, the third most populous country in Asia after China and India, the government is already acting to limit imports of garments, electronics, shoes, toys and food — five large categories in which Indonesian producers are struggling to compete with China. Starting in the new year, importers of these products will have to be registered with the government, use only five designated ports for their shipments, arrange for a detailed inspection of goods before they are loaded on a ship or plane bound for Indonesia and then have every single container exhaustively inspected on arrival by Indonesia’s notoriously slow customs bureaucracy. The plan, intended to comply with W.T.O. rules, was adopted after heavy lobbying by Indonesian manufacturers and labor unions.

h/t Rybinski

The jobs argument cuts both ways. Indonesia wants jobs for its rural migrants too.

China’s export sector hasn’t experienced a sharp cyclical downturn in a long time. In 2001 global trade did contract. But that contraction didn’t hit China all that hard. It came at a time when the electronics industry was migrating to China, allowing China to increase its share of a shrinking global market. Year-over-year export growth slowed from 25% at the peak of the .com boom in 2000 to 5% — but it didn’t turn negative. In dollar terms, the y/y increase in a rolling 12m sum of China’s exports went from $50b to $15-20b. But y/y exports never fell in dollar terms.*

But China now is a much much bigger share of global trade. China’s 2008 exports — in dollar terms — will be more than five times large than its 2000 exports. That means that China is now far more exposed to the global economic cycle than it was. And this cycle looks brutal.

Korea is reporting its biggest drop in industrial production in twenty-one years. That is the kind of data point that gets my attention. I was a bit surprised to hear that the current fall is sharper than the fall that accompanied Korea’s own crisis in 97/98.

The natural instinct of China’s policy makers is to do what they can to support employment in China’s export sector. But there are limits to how much China can do to offset the global fall in demand. And the more the world’s biggest surplus country does to support its exports, the more frustrated the world’s deficit countries are likely to become …( THAT'S IT )

Pettis is right. If the deficit countries are the ones most willing to use macroeconomic policy to support demand and the surplus counties are among the most reluctant to run expansionary macroeconomic policies (Germany) or among the most inclined to subsidize their exports (China), the likely result is a widening deficit (meaning non-oil deficit) in the deficit countries — i.e. bigger imbalances among the oil-importing economies– even as activity in all economies slows. That adds to the risk of future trade conflict. Signs of future trouble aren’t hard to find even now. ( ALL TRUE )

*1998 and early 1999 was a bit worse. Y/y export growth turned negative. But exports weren’t quite as large a share of China’s economy then — and perhaps as importantly, China wasn’t going off a long boom where exports only went up. Volatility was far more expected then."

This is all bad news, but the Saver Countries do need the Spender Countries. So, what remains to be seen are the actions or proposals that will come out of this odd scenario, where, essentially, the Saver countries don't really want to stop lending or funding the Spender countries, even as the Spender countries say that they would like to borrow and spend less. Obviously, this will happen because of the current crisis, but it's still hard for me to see a way out of this conundrum without every country becoming a Saver Country, which would be a very bad outcome, as I see it, in the short run.

Somewhere, going forward, the Saver Countries are going to have to make some tough decisions. For example, either to spend more, or let the Spender Countries selectively Default. Then, and this is what the Saver Countries want, the whole arrangement could continue.

"But don't kid yourself that the sentiment might not spread. "

Yves Smith on Beggaring Thy Neighbor:

"Has Beggar Thy Neighbor Started? ( MY THESIS IS THAT IT IS HAS BEEN GOING ON ALL ALONG, ALTHOUGH NOT FULL BLAST, BUT MODERATED. I CONSIDER ENGLAND'S ACTIONS TOWARD ICELAND BEGGARING THY NEIGHBOR, OR, BETTER YET, BUGGERING. ALSO, CHINA , JAPAN ( WITH CURRENCY AND STIMULUS ISSUES ), AND GERMANY( WITH STIMULUS ISSUES ), HAVE PLAYED A MODERATE FORM. HOWEVER, ONE COULD ARGUE THAT THEY'RE SIMPLY BUYING TIME TO GET IN A BETTER POSITION TO DEAL WITH TOUGH ISSUES.)

One of the ugly features of the Great Depression that in many (but not all) cases worsened the severity of the contraction was that countries adopted "me first" policies with little regard to their broader ramifications. The poster child of this pattern is Smoot Hawley. Although there is some dispute among economists as to whether it was as deleterious as sometimes claimed, the US increased tariffs to protect domestic employment. This proved to be short-sighted, since the US was the biggest exporter, and had a great deal to lose when other countries retaliated.

Similarly, England left the gold reserve comparatively early, in 1931. Currency devaluation proved a great help in escaping the worst of the Depression. However, competitive devaluations also limited the benefits for any one player.

We are now seeing what looks to be "devil take the hindmost" behavior. China has quietly gone back to a hard peg against the dollar (as opposed to letting the RMB do what it would otherwise do, appreciate). This is very detrimental, since it means that China is going to try to continue to rely on exports to see its way through this downturn, rather than use more aggressive fiscal stimulus( TRUE, BUT THEY HAVE A PROBLEM WITH THE STIMULUS BEING A SAVER COUNTRY ). It also means that China is trying to prop up the system of global imbalances (Chinese savings glut, US overconsumption and borrowing from China et. al.) that helped create this mess( THEY LIKE THE SYSTEM. I'VE ALREADY BLOGGED ABOUT THAT ). We need to collectively find our way out of this smoky airplane, but everyone seems to want to go back to their seats and strap themselves in.

In a very good Financial Times piece, Wolfgang Munchau in passing mentions "unsynchronised monetary policies" and suggests that the Fed's aggressive move to quantitative easing (oh, we don't dare call it that, the Fed insists its flavor is different) will force the ECB to follow suit to a fair degree. Munchau does not consider this to be a plus( I HAVE POSTED ABOUT THIS POST ):

I am sceptical about the benefits of the Fed’s new policy of quantitative easing. We do not have a liquidity crisis, but a solvency crisis, which expresses itself in large spreads and dysfunctional money markets. I cannot see how adding more and more liquidity to the system solves this problem.

Instead of propping up each bank, and swamping the market with cash, we need to restructure and shrink the banking system, as a first step to a sustainable solution to this crisis. Quantitative easing without deep structural financial reform could cause lot of trouble in the long run.

I think, however, there is a case for temporary interest rate cuts in Europe, but only on condition that this policy would be forcefully reversed once credit markets start to recover, and once the economy emerges from the slump.

But we should not delude ourselves into thinking that monetary policy can save the world. It can play a useful role, especially since we do not have the stomach for an optimal fiscal policy response. But it will not prevent the worst slump of our generation.

Ambrose Evans-Pritchard chronicles a rise in good old garden variety protectionism, so far limited to secondary and emerging economies. But don't kid yourself that the sentiment might not spread( VERY TRUE ).

It is important to keep in mind that cartoon extremes often cloud the debate. How smart is it to advocate open trade when some countries stack the deck by having artificially cheap currencies? That is tantamount to an export subsidy( BY KEEPING THE PRICE OF THEIR GOODS LOW ), but we haven't done much except jawbone China very late in the game (and the yen has been awfully cheap until recently too, and Japan has remained an export powerhouse, but we never gave them a hard time due to the sorry state of their domestic economy). Similarly, we consider it completely reasonable to restrict exports of advanced military technology, and acquisition of strategic assets.

Again, I am not saying trade is a bad thing, merely that we have often been faced with counterparties with mercantilist objectives, and our responses appear not to have served us well in the long term( TRUE ).

From Evans-Pritchard:

We are advancing to the political stage of this global train wreck. Regimes are being tested. Those relying on perma-boom to mask a lack of democratic or ancestral legitimacy may try to gain time by the usual methods: trade barriers, saber-rattling, and barbed wire...

Russia has begun to shut down trade...It has imposed import tariffs of 30pc on cars, 15pc on farm kit, and 95pc on poultry (above quota levels). "It is possible during the financial crisis to support domestic producers by raising customs duties," said Premier Vladimir Putin.

Russia is not alone. India and Vietnam have imposed steel tariffs. Indonesia is resorting to special "licences" to choke off imports...

There have been street protests in Moscow, St Petersburg, Kaliningrad, Vladivostok and Barnaul. Police crushed "Dissent Marchers" holding copies of Russia's constitution above their heads in Moscow's Triumfalnaya Square.

"Russia has not seen anything like these nationwide protests before," said Boris Kagarlitsky from Moscow's Globalization Institute....

The omens are not good in China either...

Exports fell 2.2pc in November. Toy, textile, footwear, and furniture plants are being closed across Guangdong, now the riot hub of South China. Some 40m Chinese workers are expected to lose their jobs. Party officials have warned of "mass-scale social turmoil".

The Politburo is giving mixed signals. We don't yet know how much of the country's plan to boost domestic demand through a $586bn stimulus package is real, and how much is a wish-list sent to party bosses in the hinterland without funding.
Shortly after President Hu Jintao said China is "losing competitive edge in the world market", we saw a move towards export subsidies for the steel industry and a dip in the yuan peg...

Such raw mercantilism can only draw a sharp retort from Washington and Brussels in this climate.

"During a global slowdown, you can't have countries trying to take advantage of others by manipulating their currencies," said Frank Vargo from the US National Association of Manufacturers. ( IT ISN'T GOOD, NO )

It is a view shared entirely by President-elect Barack Obama. "China must change its currency practices. Because it pegs its currency at an artificially low rate, China is running massive current account surpluses. This is not good for American firms and workers, not good for the world," he said in October. The new intake of radical Democrats on Capitol Hill will hold him to it.

There has been much talk lately of America's Smoot-Hawley Tariff Act.... The relevant message of Smoot-Hawley is that America was then the big exporter, playing the China role. By resorting to tariffs, it set off retaliation, and was the biggest victim of its own folly( TRUE ).

Britain and the Dominions retreated into Imperial Preference. Other countries joined. This became the "growth bloc" of the 1930s, free from the deflation constraints of the Gold Standard. High tariffs stopped the stimulus leaking out.

It was a successful strategy - given the awful alternatives - and was the key reason why Britain's economy contracted by just 5pc during the Depression, against 15pc for France, and 30pc for the US...

This crisis has already brought us a monetary revolution as interest rates approach zero across the G10. It may overturn the "New World Order" as well, unless we move with great care in grim months ahead. This is where events turn dangerous( COULD BE ).

The last great era of globalisation peaked just before 1914. You know the rest of the story." ( YES WE DO )

"if they start to view the pound as Europe’s equivalent of an Agency bond …"

Brad Setser on the wild ride of the dollar recently:

"Only a few days ago, so it seems, it took about $1.25 to buy a euro. Now it takes closer to $1.45 (it was more earlier today, but the dollar subsequently rallied). And — as Macro Man notes — the dollar’s move pales relative to the recent slide in the pound. Not so long ago a pound bought 1.5 euros. Now it buys a euro and change. The Anglo-Saxon currencies haven’t had a good two week run.

Both the US and the UK ( 1 ) had housing and finance centric economies. Both have ( 2 ) significant external deficits. And both are ( 3 ) inclined to use monetary and fiscal policy aggressively to combat a downturn.

But with global trade collapsing, the euro’s rise can not be all that comfortable for members of the eurozone. It isn’t clear that any one wants a stronger currency right now ( THIS MEANS THAT THEIR EXPORTS WILL BE MORE EXPENSIVE IN OTHER COUNTRIES, AND THEY DON'T WANT TO LOSE EXPORT BUSINESS DURING AN ECONOMIC DOWNTURN ). Currencies though are relative prices — and can go up or down amid a global contraction. In theory, everyone could ease monetary policy equally without changing the relative value of any currencies ( THIS WOULD KEEP THE DOLLAR HIGHER ). In practice things rarely work out as neatly ( EXACTLY ).

Dr. Krugman, I would assume, hopes that the euro’s rise puts more pressure on Germany to join a coordinated European fiscal stimulus — with good reason. Germany’s export machine relies on global and European demand. That demand is falling (watch Russian imports for example). And if the euro’s rally is sustained, Germany will soon face an additional headwind. So too will the less competitive members of the eurozone. They are in an even more difficult position if Germany doesn’t lead a coordinated European reflation. ( GERMAN EXPORTS WILL BE TOO EXPENSIVE )

Four other thoughts:

1) Until fairly recently, all the European currencies tended to move in tandem against the dollar. That meant their cross-rates were stable. And it meant that the euro wasn’t as strong as it seemed. The euro was strong against the dollar and the yen, but not against the pound, the Swedish krona, the Norwegian krona and similar currencies. Right now the euro is rising against all the smaller European currencies — not just against the dollar.

2) Japan is starting too worry about yen strength, not surprising. Renewed intervention seems like a possibility if the yen continues to rise. That shouldn’t be a surprise. Japan tends to intervene heavily when the interest different between the yen and dollar goes away, reducing private market demand for dollars.

3) China has to be pleased by the euro’s rally. Dollar strength translated into RMB strength — and a rising RMB when Chinese exports were slowing (and likely now falling) made Chinese policy makers uncomfortable. There was even talk of moving to a real basket peg — which would have meant that RMB would depreciate against the dollar when the dollar was strong. But I rather doubt that China now wants to appreciate against the dollar to offset the dollar’s renewed weakness against the euro. Right now China is happy to see the dollar and thus the RMB weaken( THAT WAY THEIR EXPORTS DON'T GET MORE EXPENSIVE FOR US ) …

4) Central banks have been big buyers of the pound over the past few years. Reserves were growing, and the pound’s share was rising. Central banks liked its yield( PAID HIGHER INTEREST ) — and the fact that it an easy alternative to both the dollar and the euro. By my count, central bank inflows often were large enough to cover the UK’s current account deficit. Central banks reserves are shooting up, but if they “rebalance” their portfolios they should be big buyers of pounds now — as they need to hold more pounds to keep the pound’s share of their portfolio up as the pound’s value slides.

I’ll be interested to see if they do so — or if they start to view the pound as Europe’s equivalent of an Agency bond …( AND NOT BUY IT AS TOO RISKY )

Notice the Chinese Contradiction:

1) They don't want the dollar to weaken so that they can export to us

2) That's happening because we're printing money

3) Yet, they tell us not to borrow too much from them, and they don't want to spend too much

Problem: On 3, it has to be one or the other

Either we borrow more and they save more

or

we save more and they spend more

"who represent competing strains of Democratic economic thought": I'm A Sort Of Non-Competative Strand

Yesterday Free Exchange commented on the post by Robert Rubin and Jared Bernstein about interest and debt, and how they are viewed in the Democratic Party. My party. Now, you might well ask where I fit in, but I've about 600 posts now trying to answer that, so let's move on:

"ROBERT RUBIN and Jared Bernstein are two left-leaning economists (both of which have advised Barack Obama) who represent competing strains of Democratic economic thought. Mr Rubin, Treasury secretary under Bill Clinton, was known as an economic centrist—pushing free trade and fiscal responsibility. Mr Bernstein is a more progressive economist, who has emphasised international labour standards and a robust social safety net.

Today, the New York Times published an opinion column co-written by Mr Rubin and Mr Bernstein. It lays out the broad areas of agreement between the two men which, one assumes, hints at what might emerge from an Obama administration. It's not particularly scary stuff—short-term stimulus, infrastructure investment, long-term fiscal discipline, sympathetic labour policies, and a trade policy that seeks to protect workers but not jobs or industries. A change in direction, to be sure, and one that deserves vigilant oversight, but not a new social democratic state."

Now, I didn't respond to this column because I also didn't see it as particularly scary or even interesting. It dealt at the level of nostrums. I'm more on Rubin's side, but I actually am concerned about Bernstein's concerns.

"What's most interesting to me are the areas where the two authors are forced to concede disagreement. One of these issues—the effect of long-run deficits on interest rates and economic growth—is one of the most contentious areas of debate for lefty economists. The authors write:

One of us (Mr. Rubin) views long-term fiscal deficits — in combination with a low national savings rate, large current account deficits and foreign portfolios that are heavily over-weighted in dollar-dominated assets — as a serious threat to long-term interest rates and our currency and, therefore, to our economic future. The other views these economic relationships as much weaker.

This is the view that shaped Clintonian deficit reduction. It also angered many Democrats, who would have preferred that increased revenues be used for a health insurance solution or public investments. Mr Rubin's position strikes me as fairly orthodox. The thing is, I'm not sure that it makes sense in light of recent events. A lot of people expected a dollar run to precipitate crisis. Instead, crisis precipitated a dollar boom."

Again, here I'm on Rubin's side. But I see the problem.

"And now, Calculated Risk is arguing that declining American deficits might result in higher long-term interest rates. Why? A reduction in the current account deficit would trim growth in foreign central bank investment in dollar-denominated assets, pushing up interest rates. In short, so long as Bretton Woods 2 held up, American deficits meant low interest rates. Only when that financial system comes apart can we expect Mr Rubin's conditions to obtain.

Mr Rubin was right about interest rates given that he was in a certain financial equilibrium, but he was wrong about which equilibrium he found himself in. Given Bretton Woods 2, and the resulting ability to borrow cheap, America should have borrowed heavily and ploughed Chinese capital into long-term domestic investments. By instead running a surplus, Mr Rubin simply made easy credit available to the private sector which, understandably, poured that credit into heavy consumption and investment in non-tradable sectors (like housing!) which weren't rendered comparatively unattractive by Chinese currency policies."

I saw the Calculated Risk post as well, and it bothered me. ( but see Setser here )

"So which should America choose moving forward? For the moment, the risk of a dollar collapse seems low, and the need for deficit spending appears high. Beyond that, we must see whether China will continue to finance American borrowing, or if China will allow domestic spending to flourish by letting the RMB appreciate. Increasingly America is learning that neither its monetary policy or its fiscal policy is as independent of international forces as it believed."

So, this really is food for thought. I agree with:

1) Risk of dollar collapse is low ( I also agree with 'seems' )

2) That's why I accept some deficit spending in the short term and a stimulus plan.

Where to go from here. Let me utter some nostrums:

1) A banking system based on Bagehot's Principles

2) Reducing government spending

3) Lower debt

4) A slight budget surplus or debt in normal times

5) Lower taxes, and fairer and more efficient taxes

I fear:

1) Inflation

But I have to admit, all these gyrations are making things hellishly complicated.

However, this post by Bob McTeer seems to echo more or less the same view, although I would disagree with him on some specifics:

"The most important near-term thing you could do to reassure financial markets and quell the turmoil is to announce early that you don't intend to eliminate President Bush's marginal tax-rate cuts. If you can't go that far, keep the adjustments as small as possible and announce your intentions to be moderate early. A little bad news early is better than great uncertainty and expecting the worse. ( I'm fine with small adjustments )

You have an education job to do. You must be able to articulate clearly how high tax rates on capital (capital gains, dividends, corporate taxes, the death tax, etc.) diminishes the demand for labor and keeps wages from rising. ( I agree )

While tax-rate increases are bad anytime, they are particularly bad in a recession. The timing couldn't be worse for a tax increase. ( I tend to agree, but the debt bothers me more )

Energy limitations must be attacked on all fronts: drill, drill, drill, nuclear, clean coal, wind, solar, and so forth. Don't push for energy independence; push for less energy dependence. ( I sort of agree, but have more environmental concerns )

Everyone knows that exports create jobs, but few focus on imports, which represent the gains from trade. Help educate people on the benefits of low prices via imports. ( I agree, basically )

Don't overdo the regulatory reaction to the current financial crisis. Another Sarbanes-Oxley is the last thing we need." ( I agree )

In other words, while things are in flux, let's stick to our general principles, while confronting reality and bending them where necessary. But like Becker and McTeer, I agree that we don't want to kill the goose that laid the golden egg.

As to Rubin and Bernstein, I'm not that bothered by either of them. I see them as sensible people. I've no fear of some massive economic shift. There will be tinkering, but tinkering can often be wise.

"and encouraged investment in interest-sensitive sectors not exposed to Chinese competition (think homes)"

Brad Setser's new post has two interesting statements to me:

"In some sense though it doesn’t really matter now that the Treasury has indicated it won’t allow systemically important financial institutions to fail: in both cases though the ultimate guarantor against losses is the US Treasury."

Great to know.

"You could argue that SAFE and the Fed have combined forces to keep the US economy afloat over the past year. SAFE financed the lion’s share of the United States external deficit – and did most of the heavy lifting earlier in the year when private investors didn’t like the dollar. The Fed’s financing has kept the US financial sector afloat. That incidentally is something that financial sector executives might want to consider as they award bonuses; many financial firms would have failed and not been able to pay anything absent taxpayer support –

On the other hand I would argue that the US shouldn’t give to much credit to SAFE for helping to stabilize the dollar earlier in the year – and for providing the US subsidized financing that has helped keep US borrowing rates fairly low. Why – because a lot of the vulnerabilities that built up in the US economy between 2003 and 2007 can be linked – in part – to large purchases of dollars by SAFE during that period. Holding the RMB down discouraged investment in the US tradable sector, and encouraged investment in interest-sensitive sectors not exposed to Chinese competition (think homes). And the rise in China’s surplus even as the oil exporters surplus was growing implied large offsetting deficits in the US and Europe. In practice that meant that Chinese demand for US assets — with more than a bit of help from US and European banks and shadow banks — supported the low level of savings and high level of borrowing in the US household sector."

I know that it might have made the low level of savings and high level of borrowing possible, but did it make it inevitable. I'm beginning to feel that it's either the products or conditions, and not the actors, who are responsible for this mess. I just don't believe it.

Here's my comment:

November 1st, 2008 at 10:16 pm
1. Don the libertarian Democrat responds:
   

   “In practice that meant that Chinese demand for US assets — with more than a bit of help from US and European banks and shadow banks — supported the low level of savings and high level of borrowing in the US household sector.”

   It’s one thing to make something possible, another to make it inevitable. Is there any place for human agency in these crises?

   Either money is too tempting, or the products are too complex. I just don’t buy it. But then, I’m no expert, just someone trying to understand how these decisions get made.