They should have been careful what they wished for: they have now got it. Enjoy!

From the FT:

"Why dealing with the huge debt overhang is so hard

By Martin Wolf

Published: January 27 2009 19:38 | Last updated: January 27 2009 19:38

How much debt is too much? Nobody knows. But the governments of highly indebted high-income economies – such as the US and UK – think they know the answer: more than today. They want even more credit to flow to their struggling private sectors. Is that an attainable ambition and, if so, how might it be achieved.

Let us start with some facts. The ratio of US public and private debt to gross domestic product reached 358 per cent in the third quarter of 2008. This was much the highest in US history (see charts). The previous peak of 300 per cent was reached in 1933, during the Great Depression.

Nearly all of this debt is private. That reached an all-time high of 294 per cent of GDP in 2007, a rise of 105 percentage points over the previous decade. The same thing happened to the UK, on a yet more impressive scale. This has been a gigantic debt and credit expansion.

Particularly remarkable is the composition of the increased debt. In the early 1930s, most US private debt was owed by non-financial companies: so balance-sheet deflation occurred in companies, as was also the case in Japan in the 1990s. This time, however, the big increase in debt was in the financial and household sectors.

Over the past three decades the debt of the US financial sector grew six times faster than nominal GDP. The consequent increases in its scale and leverage explain why, at the peak, the financial sector allegedly generated 40 per cent of US corporate profits. Something decidedly unhealthy was going on: instead of being a servant, finance had become the economy’s master. In a superb brief account of today’s calamity, Lord Turner, chairman of the UK’s Financial Services Authority, refers explicitly to “illusory profits”*.

Moreover, household debt – much of it associated with housing – also rose rapidly: from 66 per cent of US GDP in 1997 to 100 per cent in 2007. A slightly bigger jump in household indebtedness can be seen in the UK.

What do such rises in indebtedness portend? The answer might be: nothing. After all, over the world, debt nets to zero. In principle, the ability to transfer purchasing power from lenders to borrowers is highly desirable: as a British advertising campaign once claimed, credit “takes the waiting out of wanting”. Yet people can also make big mistakes, particularly if they confuse bubbles with permanently high prices. The financial sector is particularly prone to such blunders. As Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard comment: “Systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike”**.

Once such asset bubbles burst, it becomes hard to find borrowers and lenders who are either willing or creditworthy. The over-indebted start paying down their debts, instead, as now. Desired savings also soar. Realised savings may not rise, however: incomes may collapse, instead. This is what John Maynard Keynes called “the paradox of thrift”. The result will be a slump caused by balance sheet collapse rather than attempts to control high inflation.

What then might be done?

Some recommend a “liquidation”. A chain of bankruptcy would indeed eliminate a debt overhang, as happened in the 1930s. But, with much of the economy enmeshed in bankruptcy and the financial sector imploding, a depression would result. To choose that option must be insane.

Less unappealing is organised mass bankruptcy. Proposals for an organised debt-for-equity swap in failed or enfeebled financial institutions fall into this category. So, too, does allowing courts to modify mortgage contracts. Executed efficiently and expeditiously, such ideas are attractive. Costs would fall on shareholders and creditors, not taxpayers, and so sustain the principle of private responsibility.

An opposite approach is to sustain existing levels of debt, by slashing its cost to borrowers and trying to grow out of it over many years. This is what current monetary policies seek to achieve. It is a good idea, however unpleasant to creditors. But this would not generate much additional borrowing or fresh spending; it would not stop the indebted from trying to lower their debt; and it would not restore the financial sector to health.

Yet another approach is to replace private debt with public debt. That is what recapitalisation of banks now means. Over time, private-sector debt should fall, while public-sector debt, explicit and implicit, rises. Socialising debt increases the chances of growing out of it. That has happened before, notably in the case of UK public debt over the course of the 19th century.

Finally, there is inflation. If central banks and governments are aggressive enough, they can generate inflation, which will lower the debt burden. But they will imperil – if not terminate – the experiment with unbacked fiat (or man-made) money that started in 1971.

So which is the best approach?

At the overall level, it must largely be to grow out of the debt overhang, with socialisation of a part of it an essential element. Relapse into inflation would be a huge policy failure. A plan is also needed to deal with the plight of many households and with the overextended and undercapitalised financial sector.

The financial sector, as a whole, cannot deleverage by selling assets. It would be helpful if claims of global financial institutions could be netted out, instead, though that would require international co-operation. The Obama administration must also soon launch a recapitalisation of US banking, but not by buying the “toxic assets” at above-market prices. A debt-equity swap would be preferable. If that is politically impossible or too destabilising, publicly financed recapitalisation is inevitable. Just do not dare to call it nationalisation.

Whatever is done, one compelling truth cannot be evaded. It is going to be very hard to generate substantial net borrowing by households and non-financial corporations in the high-income countries with high internal debt. It is unimaginable that they will return to levels of private-sector borrowing, spending and increases in debt that characterised these countries for so long. Countries with large current account surpluses have long demanded an end to the profligate borrowing and spending of the customers upon whom they depended. They should have been careful what they wished for: they have now got it. Enjoy!"

And me, although it won't be posted:

Comments

“Countries with large current account surpluses have long demanded an end to the profligate borrowing and spending of the customers upon whom they depended. They should have been careful what they wished for: they have now got it. Enjoy!”

I’m wondering why more people aren’t concerned that the only way to break up the Saver Country/Spender Country Symbiosis involves severe social dislocation. You’re talking about countries accepting forms of behavior that they do not find pleasant, and might well not find fair. One wonders if the Saver Countries shouldn’t simply forgive some debt, or allow spender countries to use inflation to get out of this mess. What I don’t yet see is a proposal in which both sides of this union win.

Posted by: Don the libertarian Democrat | January 30th, 2009 at 5:49 am | Report this comment Your comment is awaiting moderation.

"The bigger point, however, is not that the package needs to be larger, although it does."

Martin Wolf on the FT:

"Why Obama’s plan is still inadequate and incomplete

By Martin Wolf

Published: January 13 2009 18:28 | Last updated: January 13 2009 18:28

Last week, President-elect Barack Obama duly unveiled his American recovery and reinvestment plan. Its title was aptly chosen, for Mr Obama spoke, astonishingly, as if the policies of the rest of the world had no bearing on the fate of the US. He spoke, too, as if a large fiscal stimulus would be enough to restore prosperity. If that is what he believes, Mr Obama is in for a shock. The difficulties he confronts are much deeper and more global than that.

EDITOR’S CHOICE

Economists’ forum - Oct-01

Every week, 50 of the world’s most influential economists discuss Martin Wolf’s articles on FT.com

I have little doubt that his advisers are telling the president-elect just this. The points they are – or should be – pressing on him are these.

First, the Japanese policymakers who told everyone the US was in danger of falling into a prolonged period of economic weakness were right. To understand why this is true, you need to read a brilliant book by Richard Koo of the Nomura Research Institute*. In this, he explains how the combination of falling asset prices with high indebtedness forces the private sector to stop borrowing and pay down debt. The government then inevitably emerges as borrower and spender of last resort. Because the Japanese government knew this at least, the country suffered a prolonged recession rather than a slump.

It has long been argued that the US could not suffer like Japan. This is wrong. It is true the US has three advantages over Japan: the destruction of wealth in the collapse of the Japanese bubble was three times gross domestic product, while US losses will surely be far smaller; US non-financial companies do not appear grossly overindebted; and, despite efforts by opponents of marking assets to market, recognition of losses has come far sooner.

In other respects, however, the US is still more vulnerable than Japan, after its recent debt binge (see chart). The rest of the world’s economy was big and dynamic enough to sustain Japan’s exports, but the whole world is now in recession; moreover, the US is both a deficit and a debtor country( A SPENDER COUNTRY ). Mrs Watanabe trusts her government. How far does she trust Uncle Sam? How far, indeed, does Hu Jintao?( MORE THAN YOU THINK )

Any complacency about US recovery prospects is perilous. Moreover, the fact that the US has a structural current account deficit has bearing on the second point Mr Obama’s advisers must make. Fiscal stimulus is a necessary palliative for a debt-encumbered economy afflicted by falling asset prices. But the likely longevity and scale of the needed fiscal deficits are quite scary.

In last week’s column (“Choices made in 2009 will shape the globe’s destiny”, January 6) I argued that the debt-encumbered US private sector would now be forced to save (see chart). The excess of income over expenditure in the private sector might be, say, 6 per cent of GDP for a lengthy period. If the structural current account deficit remained 4 per cent of GDP, the overall fiscal deficit would need to be 10 per cent of GDP. Moreover, this would be the structural – or full employment – deficit.

The Congressional Budget Office forecasts that US output will be 7 per cent below potential over the next two years, on unchanged policies. If so, the actual deficit should now be much larger than the structural one. It is easy to see, therefore, why the critics argue that the Obama plan for an additional fiscal stimulus of 5 per cent of GDP over two years is too small, even though the CBO forecasts a baseline deficit of 8.3 per cent of GDP this year. It is also easy to understand why many object strongly to tax cuts, since the more likely cuts are to be saved the larger the package must be – and, in addition, taxes will clearly have to rise in the longer term.( TRUE )

The bigger point, however, is not that the package needs to be larger, although it does. It is that escaping from huge and prolonged deficits will be very hard. As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment.

That leads to the third point Mr Obama’s advisers must make. This is that running huge fiscal deficits for years is indeed possible. But the US could get away with this only if default were out of the question.( ONLY FROM THE POINT OF VIEW OF THE US. THE SAVER COUNTRIES MIGHT CONSIDER IT. )

At the end of the Napoleonic wars, the UK had a ratio of public debt to GDP of 270 per cent. This was brought down over a century: growth, the gold standard and the commitment to balanced budgets did the trick (see chart). The question is how much debt the US (or UK) can accumulate now. My guess is that the US could hope to run large deficits for years if these were used to finance the creation of high-quality assets. But the policy could not safely endure throughout a two-term presidency.

Yet, contrary to widespread belief in the US, a swift return to small fiscal deficits, high employment and rapid growth will not occur spontaneously. It is necessary to make structural changes in the US and world economies first. This is the last point Mr Obama’s advisers must make.

What then are these changes?

First, there must be a credible programme( GIVE ONE AS AN EXAMPLE PLEASE ) for what Americans call “deleveraging”. The US cannot afford years of painful debt reduction in the private sector – a process that has still barely begun. The alternative is forced writedowns of bad assets in the financial sector and either more fiscal recapitalisation or debt-for-equity swaps. It also means the mass bankruptcy of insolvent households and forced writedowns of mortgages.( I DON'T UNDERSTAND THIS. IT HAS TO BE PAINFUL BUT IT CAN'T BE PAINFUL. )

All this would also lead to big one-off increases in public debt( I THOUGHT WE HAVE TO LOWER DEBT ? ). But those increases would probably be much smaller than those generated by a decade of huge fiscal deficits. The aim is to have a slimmer and better-capitalised financial system and a healthier non-financial private-sector balance sheet, sooner rather than later. The troubled asset relief programme should be used for these purposes. It will need to be bigger( IT NEEDS TO BE SLIMMER BUT BIGGER ).

Second and most important, the structural current account deficit has to diminish. The US private sector is no longer in a position to run huge financial deficits as an offset to the demand-draining external deficits. The public sector can do so only for a few years. In the long run, the world economy must be sustainably and healthily rebalanced( WHY ? ). This is a huge challenge for international economic diplomacy. It is also an essential element of sound domestic policy( GOOD LUCK ).

Mr Obama must be fully persuaded of these last points. If the fiscal deficits are to fall sharply in the medium term, as they need to, the new president needs effective programmes for private sector deleveraging and global reform and adjustment. The fate of the US cannot be determined in isolation. What this should mean will be the subject of next week’s column.

*The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Wiley, 2008)

martin.wolf@ft.com"

I find this post puzzling. I'm not sure what he's recommending.

"is it true that Americans are fundamentally spenders? "

Accrued Interest with some good points:

"2009 Forecast: That bad huh?

For most of my career, with an exception here and there, there have been two persistent trends. One is that in the debt markets, the fundamental outlook has generally been good. You had persistently low inflation, mostly low volatility, and a growing economy. Sure, some bonds went bad, but for the most part, the fundamental picture was good. The problem was always valuation. You'd look at a corporate bond and see a whopping 100bps spread or something and it would seem like all downside, no upside risk. But of course, you had to buy something, so you'd hold your nose and buy it.


Now its just the opposite. The fundamental outlook is piss poor, but the valuations look extremely cheap across all risk sectors.( I AGREE )


Risk assets are pricing in Armageddon( I AGREE ). As long as no one spies any horsemen running around, those risk assets ought to pay off well for investors in the very long term. But that's the real trick isn't it? When to jump in?


I think the key to bond investing in 2009 is two fold.


1) Protect your liquidity. Professional investors, whether leveraged or not, never know when their clients will need cash. And the cost of turning bonds into cash has never been higher than now. Non-pros tend to underestimate the probability of needing cash, and frankly, non-pros don't have as many resources for producing liquidity in bonds. No offense, but its true.


I believe that liquidity has probably bottomed( I AGREE ), or put another way, that liquidity won't get any worse than it is now. But when I say probably I mean like 65%. There is still a decent chance of another blow-up causing another spate of deep illiquidity.( PLEASE NO )


That being said, bid/ask levels are going to remain very wide, probably for the next several years. We've seen improved liquidity in high-quality sectors, like agencies and munis, but even there, I expect liquidity to wax and wane with buyer demand. Remember that dealers used to be the guardians of liquidity. That's gone and it ain't coming back.


2) Buy what you can hold. This isn't to say you can't put money into a bond as a trade, but given how wide bid/ask is, and given that you don't know when bids are going to suddenly disappear, you can't assume you can flip a position. So when buying a bond, ask yourself: would I hold this bond for the next year? Two years? To maturity? Is this credit strong enough that, if I had to, I'd hold this bond indefinitely?


I argue that you shouldn't buy anything in 2009 where you can't answer that question with a confident yes.


So with all that being said, here is my basic economic forecast for 2009. I'll follow this post up with thoughts on some of the major bond sectors. As always, I'll discuss a most likely scenario along with a less likely but possible scenario.


Growth
Most Likely: Sharply negative real growth in 4Q 2008, continuing (at a less severe pace) at least through 1H 2009. 2H 2009 likely near zero. Meaningful recovery doesn't start until 2Q 2010.

Less Likely: Government fumbles stimulus, and growth is negative through 2010 and possibly into 2011, with a deeper trough.

I think the immediate period after the Lehman/AIG/GSE/WaMu/Wachovia failures resulted in a massive pull back in economic activity( YES ). We saw it in Existing Home Sales in October/November, in auto sales activity, bank lending, everything.

That took what was already going to be a recession and turned it into something much worse( I AGREE ). I had thought that mortgage foreclosures could bottom in mid-2009, because that seemed like long enough for the bad loans to burn out. But the sharp contraction in 4Q 2008 will result in much higher unemployment, I suspect around 10% by the end of 2009, and thus the foreclosure party will continue on.

And it will take a slowdown in foreclosures for housing prices to bottom. I suspect it will be government intervention( NECESSARY ) that is the catalyst for this. We've already seen the government move to lower mortgage rates, which really should give us pretty good affordability. And while part of the initial problem with housing was over-building, but that ship has sailed. Housing starts have plummeted, and now all starts are pretty much multi-family or made to order.

Anyway, you need demand to outstrip supply in order for prices to start rising. As long as foreclosures are rising, that means supply is rising. Demand is going to be tepid until the employment picture improves. Rising supply and unchanged demand equals falling prices.

So I see home prices falling throughout 2009, absent direct government intervention either buying foreclosed properties or subsidizing banks to prevent foreclosures. Obama & Co. may actually take these steps, but I'd say it'll take several months for such a thing to pass Congress, then several more months to actually be implemented. So we're still looking at late 2009 at best.

GDP growth will probably be worst in 4Q 2008, then more modestly negative in 1Q and 2Q 2009. Beyond that is difficult to say. My base case is for 2H 2009 to be about zero real GDP growth, with a meaningful but tepid recovery in beginning in 2Q 2010.

The risk to this forecast is that the government bungles the bailout attempts, most likely by letting another financial institution fail( GOD NO ). It currently doesn't look like that's their strategy, but then again, after Bear Stearns it didn't seem like they wanted to let another institution fail. But then came Lehman.( YEP )

Another risk to this forecast is...

Inflation
Most Likely: Inflation? What inflation? The Fed will spend most of 2009 fighting deflation, although by 3Q or 4Q it will be apparent that the Fed will indeed win the battle. Headline CPI will print negative multiple times in 1H 2009, predominantly on falling food and energy prices.

Less Likely: We fall deeper into deflation, most likely because the less likely growth scenario comes to pass.

I've written a few times on deflation, which is truly the primary concern of the Fed right now. The Fed has plenty of tools to fight it, and Ben Bernanke is the right man for the job, having spent his academic life studying how the Fed blew it in the 1930's.

I don't see Japanese-style deflation taking hold, at least not for the same reasons as it took hold in Japan. The Bank of Japan maintained a ZIRP policy for many years to no avail. They still suffered from deflation. Why? Because you can't get consumer inflation without consumer spending. I argued this multiple times when energy prices were rapidly rising. Energy doesn't "create" inflation, rising money supply does.( I AGREE )

But even in the face of rapidly rising money can't create inflation unless consumers are spending. Right now, money is contracting and consumers are pulling back. In fact, those two things are usually correlated. But in the case of Japan in the 1990's, consumers refused to spend despite massive fiscal and monetary stimulus.

But here is where I think the U.S. differs from Japan. The Japanese are fundamentally savers. Americans are fundamentally spenders.( I AGREE )

Unemployment is going to be bad in 2009, heading toward 10%. But the other 90% of Americans will keep spending their income. Now they won't be able to spend their home equity, as in the past, but basically we're a nation of spenders( I AGREE ). Once the American stimuli take hold, consumer spending will advance anew. That's not to mention the fact that the U.S. Fed has been far more aggressive far earlier than the BoJ ever was.

Eventually this leads to some inflation problems( TRUE ), probably not till 2H 2010. To suggest that the Fed will provide just enough stimulus to avoid deflation but not create a significant inflation problem down the road is ridiculous( SO ARE MY FORECASTS ).

Key to the Fed's success is the progress on quantitative easing. The TALF is the quintessential example of QE, where the Fed targets interest rates away from overnight bank lending rates. There will be no limit as to how far the Fed goes to fight deflation. They could buy corporate bonds, municipal bonds, commercial mortgages, anything( TRUE ). Beware what you short!

However, if we get another big leg downward in economic growth, resulting in even tighter consumer lending conditions, then the deflation fight becomes more difficult. I'd still see the Fed eventually winning, but such an outcome would result in a much longer period of ZIRP and eventually much bigger inflation spike.

In the next couple days, I'll be discussing my investment strategy around this forecast."

Now Paul Kedrosky:

"Interesting contention over at Accrued Interest:

The Japanese are fundamentally savers. Americans are fundamentally spenders.

Is it always and forever true that Americans are spenders? I’ll concede upfront that the Japanese are savers, and that Americans have for more than fifteen years been crummy savers, but is it true that Americans are fundamentally spenders? Is it not possible that we could see a state change here given what has happened in stock markets and housing, etc.?( IT IS POSSIBLE, BUT I WOULD SAY ONLY AS A RESULT OF A REALLY BAD RECESSION OR DEPRESSION. OTHERWISE, WE ARE A NATION OF SPENDERS. )

I’m unconvinced that it can’t change. I could cite the recent uptick in spending in the U.S., post stimulus, with BLS showing U.S. savings rates up to 2.8% or so, which is a big increase in a short amount of time. I’m on record as saying the U.S. personal savings rates hits 7% in short order, and stays there, at least for a while.( I SEE MORE LIKE 3-5 %. BUT SHORT TERM MEANS A REVERSION TO OUR NATURAL STATE AS SPENDERS. )

Feel free( THAT'S WHY NOTHING IS WRITTEN ) to take the other side."

"It is becoming easier and easier to find signs of trade tensions and potential for friction."

Now Pettis:

"The Ox approaches( WHOSE WILL GET GORED?) January 2nd, 2009 by Michael | Filed under Exports and imports, Trade protection.

It is becoming easier and easier to find signs of trade tensions and potential for friction( UNWINDING THE SAVER/SPENDER SYMBIOSIS WILL INEVITABLY CREATE BOTH ). On Tuesday’s post I already mentioned the fact that South Korea had shifted from deficits to surpluses, and that Vietnam had devalued the dong as a reaction to falling exports. Yesterday’s Financial Times has the kind of article I expect to see a lot more of in the coming months:

Western countries should close their markets to sales of Chinese trains because China’s domestic market is closing to outside suppliers, says the head of one of the world’s largest rolling stock builders. In a Financial Times interview, Philippe Mellier, chief executive of Paris-based Alstom Transport, also claimed that Chinese companies were offering trains for export using technology derived from western suppliers. Such technology is usually supplied on condition it not be used outside China. The comments by Mr Mellier, whose company is the world’s number two trainmaker, underline the growing tension in the world’s train-building industry over China’s role.

A recent Washington Post article listed a number of trade-related measures:

Only a few weeks after world leaders vowed at a Washington summit to reject trade protectionism and adhere to free-market principles( THEY HAVEN'T BEEN FROM THE BEGINNING ) as they combat the global financial crisis, a host of nations are already breaking that promise.

Moving to shield battered domestic manufacturers from foreign imports, Indonesia is slapping restrictions on at least 500 products this month, demanding special licenses and new fees on imports. Russia is hiking tariffs on imported cars, poultry and pork. France is launching a state fund to protect French companies from foreign takeovers. Officials in Argentina and Brazil are seeking to raise tariffs on products from imported wine and textiles to leather goods and peaches, according to the World Trade organization.

At the same time The Wall Street Journal had a related article with a conflicting message:

The U.S. current account deficit narrowed more than expected in the third quarter as a broad gain in exports outstripped the rise in imports. The current account deficit decreased to $174.1 billion during the July through September period, from a downwardly revised $180.9 billion in the second quarter, the Commerce Department said Wednesday. The second-quarter deficit was originally reported as $183.1 billion.

Obviously enough if the US current account deficit decline – about 90% of which is the trade in goods and services – other countries current account surpluses must also decline( THAT'S IT ). Continuing on that subject Brad Setser has a post( I JUST POSTED ON IT ) today in his blog on the subject:

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 whole Korean story has been an interesting one which I have been watching peripherally with great interest. The collapse in Korean export was a real warning signal for China because one of the few export areas for China that held up until recently had been sales of machinery and capital goods, but those have always been important areas for Korean exports and the very weak demand for Korean machinery boded ill for China.

There is not much else to report since today most things in China were closed, including the stock market. The last time I mentioned the stock market was on December 9, when the SSE Composite had traded up sharply the day before to close at 2091. Since then it has declined pretty steadily, with only five up days, to close yesterday at 1821, down 12.9% albeit on very thin volume. We are racing towards Chinese New Year and I suspect everyone is eager to put the Year of the Rat behind them. It is the first year in the cycle and is supposed to be a time of hard work and renewal. It ends in three weeks and will be followed by the Year of the Ox, which symbolizes prosperity through fortitude. We’ll see — fortitude will probably be necessary."

Since I found the use of Terrorism Laws to skewer Iceland so offensive, even as Gordon Brown was telling everyone not to beggar your neighbor, I'm going to say that the skewering of Iceland was an example to other countries that not beggaring your neighbor is a farce. After all, what do you call the current situation in Iceland?

"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.

" they will now be contributing their net supply. This will not help the world imbalances"

From Michael Pettis on China Financial Markets:

"Everyone is working hard to increase global trade imbalances December 30th, 2008 by Michael | Filed under Balance of payments, Consumption and production, Exports and imports, Informal banks.

I suspect most of my readers outside China are more interested in enjoying the holiday season than in spending much time following my blog, while most of my readers inside China are focusing on upcoming exams, but anyway my recent writing commitments are so intense that I haven’t been able to post much recently. For what it is worth I have a short piece appearing soon on YaleGlobal Online about why the US-China trade relationship was the “cause” of the recent financial crisis. ( INTERESTING )

I have a much longer piece that will appear in the January issue of the Far Eastern Economic Review that sets out the balance-of-payments framework necessary, in my opinion, for understanding not just how the current crisis came to pass but also how bad it can become if policymakers do not react correctly. The Financial Time’s Martin Wolf has kindly asked me to prepare a shorter version of the piece to appear on the FT blog next month.

Still, for all the writing commitments, there are a few things I wanted to note in my blog entry today. Today’s New York Times has an interesting article on South Korea that I suspect is going to set the tone for a lot of what will happen in the upcoming months:

South Korea posted a current-account surplus for a second consecutive month in November, which may help ease pressure on the won, the region’s worst-performing currency this year. The surplus was $2.06 billion, compared with $1.67 billion in November 2007, the Bank of Korea said…The nation posted a record $4.75 billion excess in October…South Korea has posted current-account shortfalls every month but three this year as higher oil prices and the weaker won drove up the cost of imported goods.

A few days ago the Financial Times had another interesting, related piece.

Vietnam devalued the dong by 3 per cent on Thursday in its latest attempt to keep its export-dependent economy afloat. The government said that 2008 economic growth had shrunk to 6.23 per cent from 8.5 per cent last year and there were signs it was likely to slow further in 2009. Several analysts have warned of the threats of competitive devaluations among Asia’s exporting economies but Hanoi’s move comes after spending most of the year trying to maintain the currency’s strength to slow spiralling inflation.

…Several analysts noted that while governments have resisted pressure for protectionist policies, there are fears they might take the short cut of devaluation. Thailand and Taiwan have recently become net purchasers of dollars, provoking the Asian Development Bank to warn against “unnecessary and excessive interventions in the currency markets, especially to depreciate domestic currencies”.

Vietnam has also cut interest rates several times which, as I have argued before, in an economy whose banking system funnels credit primarily to investment, and not consumption, is as much as an export-enhancing measure as currency depreciation( EXACTLY. A SAVER COUNTRY ).

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply( YES ).

This will not help the world imbalances( THEY AREN'T MEANT TO ). The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable( THE SAVER AND EXPORT COUNTRIES DON'T AGREE ). We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Meanwhile domestically the debate about how to respond to the global crisis is still raging, although it is far from clear that we have anything close to a consensus among policymakers. Today’s South China Morning Post has the following article:

A former mainland central banker has called for a halt to the country’s recent flurry of actions to loosen monetary policy, a view partially echoed by analysts. Wu Xiaoling, who was a deputy governor of the People’s Bank of China before she left a year ago, said deep cuts in interest rates and reserve requirement ratios intended to boost lending could backfire, damaging confidence and adding pressure to bank balance sheets.

“I don’t think we should do more on the monetary policy side,” Ms Wu, now a vice-head of the financial committee of the National People’s Congress, told the Economic Observer newspaper yesterday. “Intensive policy moves will not help stabilise market expectations. Instead, they will cause panic among companies and the public, making the situation worse.”

I am glad to see that there is increasing concern about further interest rate cuts, although not for the reasons cited by most. For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets( THAT'S WHAT WILL HAPPEN ).

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand( GOOD LUCK ), and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

While still on the subject of banking, there is another very interesting article from the South China Morning Post on pyramid schemes and underground banking. As the financial system in China contracts, in spite of regulatory attempts to force credit expansion, I think the informal banking sector is going to get increasing scrutiny. In addition, and the Bernie Madoff scandal should remind anyone who needs reminding, financial crises always result in the uncovering of financial scandals and fraud on a massive scale, which already seems to be happening here( 2nd CAUSE OF OUR CRISIS ). Rather than comment I will quote extensively from the article:

Beijing will impose severe penalties on people involved in pyramid sales schemes, underground banking or manipulation of government statistics in a move to strengthen financial security, according to draft revisions submitted to the mainland’s top legislative body yesterday.

…Mr Li said the draft was revised to define pyramid selling as “organising, leading sales activities aimed at promoting goods and providing services that require participants to pay for the products or services in order to obtain membership” and “introducing a tiered system to force or prompt participants to attract new members to extract money and property, thereby disturbing public order”. If the changes are passed, people convicted of involvement in such activity could be sentenced to up to five years in jail, while ringleaders could be given even longer sentences in more serious circumstances. A regulation targeting underground banking has also been reviewed, according to Xinhua.

Illegal banks dealing in large financial transactions will be regarded as criminal organisations, the proposed amendments say. Mr Li said his committee added this line after the Legislative Affairs Office and the Public Security Ministry highlighted how underground banking could disturb and harm the financial order. Pyramid sales and underground banking have emerged as two major social problems in the recent weeks( I'M NOT SURPRISED ).

…Illegal banks are targets despite mainland companies of varying sizes relying on them for cash in the credit crisis. Illegal banks on the border help mainland businesspeople invest in the Hong Kong stock exchange."

Happy 2009, everyone. I will spend New Year’s Eve at D22 watching an amazing lineup of some of Beijing’s most brilliant musicians. I hope to see some of you there."

As I've said, the Saver and Export Countries do not want to change the basic arrangement. They will only go so far in the direction Pettis advocates. I've talked about the possibility of forgiving US debt, and I'm sure other options are being considered. It's simply not clear that Saver and Export Countries can change politically or economically.

No matter how one wishes to describe it, the US will have to default on its sovereign debt, most likely on a selective basis

Here's a proposal that I thought China, Germany, or Japan (For Export Reasons ) might make, because the Saver Countries love the current arrangement and don't want to change. From Bloomberg:

"By Stanley White and Shigeki Nozawa

Dec. 24 (Bloomberg) -- Japan should write-off its holdings of Treasuries because the U.S. government will struggle to finance increasing debt levels needed to dig the economy out of recession, said Akio Mikuni, president of credit ratings agency Mikuni & Co.( TRUE )

The dollar may lose as much as 40 percent of its value to 50 yen or 60 yen from the current spot rate of 90.40 today in Tokyo unless Japan takes “drastic measures” to help bail out the U.S. economy, Mikuni said. Treasury yields, which are near record lows, may fall further without debt relief, making it difficult for the U.S. to borrow elsewhere, Mikuni said.( TRUE )

“It’s difficult for the U.S. to borrow its way out of this problem,” Mikuni, 69, said in an interview with Bloomberg Television broadcast today. “Japan can help by extending debt cancellations.”( TRUE )

The U.S. budget deficit may swell to at least $1 trillion this fiscal year as policy makers flood the country with $8.5 trillion through 23 different programs to combat the worst recession since the Great Depression. Japan is the world’s second-biggest foreign holder of Treasuries after China.

The U.S. government needs to spend on infrastructure to maintain job creation as it will take a long time for banks to recover from $1 trillion in credit-market losses worldwide, Mikuni said. The U.S. also needs to launch public works projects as the Federal Reserve’s interest rate cut to a range of zero to 0.25 percent on Dec. 16. won’t stimulate consumer spending because households are paying down debt, he said.( POSSIBLE )

U.S. President-elect Barack Obama wants to create 3 million jobs over the next two years, more than the 2.5 million jobs originally planned, an aide said on Dec. 20. Obama takes office on Jan. 20.

Marshall Plan

Japan should also invest in U.S. roads and bridges to support personal spending and secure demand for its goods as a global recession crimps trade, Mikuni said.

Japan’s exports fell 26.7 percent in November from a year earlier, the Finance Ministry said on Dec. 22. That was the biggest decline on record as shipments of cars and electronics collapsed.

Combining debt waivers with infrastructure spending would be similar to the Marshall Plan that helped Europe rebuild after the destruction of World War II, Mikuni said.

“U.S. households simply won’t have the same access to credit that they’ve enjoyed in the past,” he said. “Their demand for all products, including imports, will suffer unless something is done.”( TRUE )

The plan was named after George Marshall, the U.S. secretary of state at the time, and provided more than $13 billion in grants and loans to European countries to support their import of U.S. goods and the rebuilding of their industries

Currency Reserves

The Japanese government could use a new Marshall Plan as a chance to shrink its $976.9 billion in foreign-exchange reserves, the world’s second-largest after China’s, and help reduce global economic imbalances, Mikuni said.

The amount of foreign assets held by the Japanese government and the private sector total around $7 trillion, Mikuni said.

Japan will also have to accept that a stronger yen is good for the country in order to reduce excessive trade surpluses and deficits, he said. The yen has appreciated 23 percent versus the dollar this year, the most since 1987, as the credit crisis prompted investors to flee riskier assets and repay loans in the Japanese currency.( FLIGHT TO SAFETY )

“Japan’s economic model has been dependent on external demand since the Meiji Period” that began in 1868, Mikuni said. “The model where the U.S. relies on overseas borrowing to fuel its property market is over. A strong yen will spur Japanese domestic spending and reduce import prices, thereby increasing purchasing power.”

I thought that China would offer this first, but Japan's drop in exports is obviously panicking them. I'll repeat my point: It will not be easy for the Saver Nations to change, so that they will try and come up with creative plans to keep this system going. This is an example.

Now, I had actually missed this Bloomberg story, which I believe is important, but Jesse's Cafe Americain picked it up. So here's Jesse's take:

"Japanese Economist Urges Selective Default on US Treasury Debt

Here is an interesting proposal for a 'selective default' of US Treasury debt to head off a massive devaluation of the dollar, and to promote the US recovery from the ravages of its self-inflicted financial damage.

No matter how one wishes to describe it, the US will have to default on its sovereign debt, most likely on a selective basis, writing down the rest through an inflated dollar. The Japanese recognize this and are volunteering a tentative plan to accomplish it to support their industrial policy.

Although there is a potential for a voluntary debt forgiveness from Japan as a loyal client state, we wonder if the rest of the world will be inclined to support an unreformed dollar hegemony.

Can the economic world so woefully lack the will, knowledge, and the imagination to develop a more equitable mechanism for international trade?

Financial reforms, although not even on the table yet, are certain to come with any sustained recovery. There has been nothing even seriously proposed yet as Bernanke and Paulson rush to supply fresh capital to prop up the status quo and aid their cronies on Wall Street.

We can surely do better than this."

I disagree. From the point of view of the Saver Countries, this would be the easiest and cleanest solution, and would allow the symbiosis of Saver and Spender Countries to continue. If not this, they will soon be floating other similar options.

"As was the case in the 1930s, we also have a choice"

Martin Wolf on Keynes on the FT:

"We are all Keynesians now. When Barack Obama takes office he will propose a gigantic fiscal stimulus package. Such packages are being offered by many other governments. Even Germany is being dragged, kicking and screaming, into this race.

The ghost of John Maynard Keynes, the father of macroeconomics, has returned to haunt us. With it has come that of his most interesting disciple, Hyman Minsky. We all now know of the “Minsky moment” – the point at which a financial mania turns into panic.

Like all prophets, Keynes offered ambiguous lessons to his followers. Few still believe in the fiscal fine-tuning that his disciples propounded in the decades after the second world war ( TRUE ). But nobody believes in the monetary targeting proposed by his celebrated intellectual adversary, Milton Friedman, either( TRUE ). Now, 62 years after Keynes’ death, in another era of financial crisis and threatened economic slump, it is easier for us to understand what remains relevant( I SAY USEFUL ) in his teaching.

I see three broad lessons.

The first, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”( I AGREE ).

The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company, it makes sense to cut costs. If the world tries to do so, it will merely shrink demand( AS A WHOLE, I CAN UNDERSTAND THIS ). An individual may not spend all his income. But the world must do so( TRY TO ).

The third and most important lesson is that one should not treat the economy( ECONOMICS IS FINE HERE ) as a morality tale( HERE I DISAGREE COMPLETELY. MORALITY IS PART OF POLITICAL ECONOMY ). In the 1930s, two opposing ideological visions( THERE WERE OTHERS, THANKFULLY DEFEATED ) were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order(I DON'T AGREE WITH HIM HERE. VON MISES CRITIQUE OF SOCIALISM WAS MORE THAN A MORALITY TALE, AND SO WERE HAYEK'S VIEWS ABOUT THE MARKET AND THE DANGERS OF TOO MUCH STATE CONTROL); the latter in the idea that the identical motivation could lead only( IT WAS THIS MECHANISTIC APPROACH TO POLITICS AND POLITICAL ECONOMY THAT MADE MARXISM, FOR EXAMPLE, NOT SUITABLE FOR HUMAN CONSUMPTION ) to exploitation, instability and crisis.

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge( WRONG ). He wished to preserve as much liberty as possible( I AGREE. AS DO I. ), while recognising that the minimum state( HERE I DISAGREE ) was unacceptable to a democratic society with an urbanised economy( I CAN FORESEE A TIME OF LESS GOVERNMENT INVOLVEMENT, BUT THIS IS CURRENTLY TRUE ). He wished to preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds( I WOULD SEEM TO AGREE WITH HIM ).

This same moralistic debate is with us, once again. Contemporary “liquidationists” insist that a collapse would lead to rebirth of a purified economy( COMPLETELY UNBURKEAN ). Their leftwing opponents argue that the era of markets is over. And even I wish to see the punishment of financial alchemists who claimed that ever more debt turns economic lead into gold( I WOULD LIKE TO SEE THE PUNISHMENT OF CRIMINALS ).

Yet Keynes would have insisted that such approaches are foolish. Markets are neither infallible nor dispensable( TRUE. THEY ARE USEFUL. ). They are indeed the underpinnings of a productive economy and individual freedom( TRUE ). But they can also go seriously awry and so must be managed with care( TRUE ). The election of Mr Obama surely reflects a desire for just such pragmatism( TRUE ). Neither Ron Paul, the libertarian, nor Ralph Nader, on the left, got anywhere( TRUE ). So the task for this new administration is to lead the US and the world towards a pragmatic resolution of the global economic crisis we all now confront.( I AGREE )

The urgent task is to return the world economy to health.

The shorter-term challenge is to sustain aggregate demand( YES ), as Keynes would have recommended. Also important will be direct central-bank finance of borrowers( YES ). It is evident that much of the load will fall on the US, largely because the Europeans, Japanese and even the Chinese are too inert, too complacent, or too weak( TOO MUCH BEGGARING ON THEIR PART ALREADY ). Given the correction of household spending under way in the deficit countries( SPENDER COUNTRIES ), this period of high government spending is, alas, likely to last for years( BTREATHE DEEPLY MATE ). At the same time, a big effort must be made to purge the balance sheets of households and the financial system. A debt-for-equity swap is surely going to be necessary( IT WON'T NEARLY BE AS LARGE AS HE THINKS. TOO MANY PEOPLE WANT THE OLD SYSYEM BACK. IT SUITS US. ).

The longer-term challenge is to force a rebalancing of global demand. Deficit( SPENDER ) countries cannot be expected to spend their way into bankruptcy( TRUE ), while surplus ( SAVER )countries condemn as profligacy the spending from which their exporters benefit so much( THAT'S WHY THEY'RE STRUGGLING TO KEEP THIS SYSTEM ). In the necessary attempt to reconstruct the global economic order, on which the new administration must focus, this will be a central issue. It is one Keynes himself had in mind when he put forward his ideas for the postwar monetary system at the Bretton Woods conference in 1944.

No less pragmatic must be the attempt to construct a new system of global financial regulation and an approach to monetary policy that curbs credit booms and asset bubbles( WE'LL TRY ). As Minsky made clear, no permanent answer exists( TRUE ). But recognition of the systemic frailty of a complex financial system would be a good start( OK ).

As was the case in the 1930s, we also have a choice: it is to deal with these challenges co-operatively and pragmatically or let ideological blinkers and selfishness obstruct us ( I AGREE ). The objective is also clear: to preserve an open and at least reasonably stable world economy that offers opportunity to as much of humanity as possible( I AGREE ). We have done a disturbingly poor job of this in recent years. We must do better. We can do so, provided we approach the task in a spirit of humility and pragmatism, shorn of ideological blinker. ( WE GET THE POINT )

As Oscar Wilde might have said, in economics, the truth is rarely pure and never simple. That is, for me, the biggest lesson of this crisis. It is also the one Keynes himself still teaches( I AGREE )."

He gets a bit simplistic, but I generally agree with what he's saying, except for the fact that, long term, I believe that less government with a growing and balanced economy is possible. Keynes view is still too rooted in the 30s to be of major use to us undigested, and is much too pessimistic and mechanistic, as that era tended to be. Again, Political Economy and Politics are underpinned by the context and presuppositions of the time.

What Keynes offers us is a little useful wisdom and a narrative of perceived success at helping the world out of a crisis, which goes a long in times like these.

"One simple way to do this would be to allow all corporations to postpone payment of corporate income taxes for 1-2 years."

Daniel Gros on Vox chucks a few proposals our way:

"Most countries need a fiscal stimulus ( CERTAINLY SAVER COUNTRIES DO ), but how should it be implemented? This column assesses fiscal policy's potential to increase demand and argues that any meaningful boost must come from transfers to the private sector, not infrastructure investments. Tax cuts will be most effective in countries where households are net borrowers( SPENDER COUNTRIES, LIKE OURS ).

As the real economy sinks quickly into a deep recession, governments are groping( IN THE DARK ) for measures to limit the downturn. And as interest rates are quickly bumping against the zero bound, an aggressive use of fiscal policy seems to be the only way to sustain demand( CONSUMPTION ). Fiscal policy seems particularly appropriate since our macroeconomic models tell us( YIKES ) that fiscal policy multipliers increase when more economic agents become liquidity constrained( HAVE NO MONEY TO SPEND ) because they are then likely to spend any additional income they receive( GEE WHIZ ).

Unfortunately the discussions about the appropriate use of fiscal policy have degenerated into a shouting much with accusations of ‘crass Keynesianism’ and ‘stupid fiscal orthodoxy’. Instead of engaging in such polemics, one should look calmly( PREFERABLY IMBIBING SOMETHING SOOTHING ) at what fiscal policy can actually achieve under the present extraordinary ( NO IDEA WHAT TO DO ) circumstances.

"The key question: Can fiscal policy increase demand effectively? ( I BELIEVE THAT THIS IS TYLER COWEN'S QUESTION )

The most direct way for governments to increase demand is to buy goods and services from the market. However, most European governments spend very little this way. Public sector investment represents only 2–2.5% of GDP and is difficult to increase quickly since the large projects( INFRASTRUCTURE ), which make up the bulk of the expenditure, take often a decade or more to realize. Even if governments were able to increase public investment by 20% in one year, this would result in a fiscal impulse of only less than 0.5% of GDP. Even in the US, this instrument will only have limited importance( I AGREE, BUT IT WILL HELP, AND IT NEEDS TO BE INVESTMENT, WHICH WILL HELP THE ECONOMY GOING FORWARD ), as public infrastructure spending is projected to increase from around 2.6% (in 2007) to 3.6% of GDP (in 2009), thus constituting only a small fraction of the overall deficit, which is now projected to climb to around 8%–9% of GDP.

Any large-scale fiscal policy impulse must therefore, to be effective quickly, work through transfers to the private sector, either via lower taxes or via higher transfer to households ( WE HAVE TO DO SOME OF THIS FOR SOCIAL SAFETY NET PURPOSES ). The key problem here is that under the present circumstances of extreme uncertainty households might just save any increase in their disposable income( THAT'S THE RISK ). How likely is this to happen? A key factor will be the financial position of households themselves ( TRUE ).

Households that depend on credit to finance their consumption will be most affected by the credit crunch and are thus most likely to react to a tax cut by maintaining their consumption. For this type of household, a tax cut (or an increase in expenditure) will be an effective tool to prevent an even sharper drop in consumption( MAKES SENSE ).

However, for households that do not depend on credit, the situation is quite different. Households that are saving anyway will probably at present just increase their savings in response to an increase in their disposable income that they know to be temporary( SAVER COUNTRIES LIKE GERMANY AND CHINA ).

This implies that the effectiveness of fiscal policy will vary greatly across the EU. Table 1 shows that households are on average net borrowers in only two of the larger member countries – Spain and the UK, unsurprisingly. In these two countries (with the largest housing bubbles) fiscal policy should thus be effective. However, in the three other large member countries, households are on average net savers. In these countries, and in particular in Germany where households are net lenders to the tune of about 10% of their disposable incomes, fiscal policy will not be effective – households can just increase their lending in response to a tax cut. The experiences of the US and Japan point in a similar direction. In Japan, the government has been running very large deficits for over a decade, but an increase in private savings has offset this, leaving domestic demand flat. Even in the US, where the private savings rate has been close to zero, households still chose to save more than half of the tax rebate decided earlier in 2008.

Table 1. Household lending across the EU

	Net lending of households		Net lending of corporations
	Billion euro	Percentage of income	Billion euro
Germany	+144	9.5%	+46
Spain	-27	-4.4%	-75
France	+66	5.4%	-0
Italy	+63	6.4%	-58
UK	-97	-8.2%	+98

Source: Ameco

The fact that the marginal propensity to save is likely to be much higher in countries with solvent households (Germany and most of rest of continental Europe) also implies that the multiplier effect of spending on public infrastructure will also be lower than in the Anglo-Saxon countries where households are close to bankruptcy. This is another reason why the German government should be more hesitant than others to engage in a big fiscal stimulus ( THEY HAVE SOCIAL SAFETY NET AND INFRASTRUCTURE POSSIBILITIES, AS MERKEL HAS DECIDED ).

A similar reasoning applies to the corporate sector – in a credit crunch investment will be strongly affected by the liquidity situation of enterprises. This implies that in countries where the corporate sector is a heavy borrower (Spain, France and Italy) it would be important to improve the liquidity situation of enterprises. One simple way to do this would be to allow all corporations to postpone payment of corporate income taxes for 1-2 years( THIS IS SOMETHING THAT I'VE BEEN CALLING FOR ). This would not result in higher deficits as usually measured, but the cash deficit would increase as governments would effectively extend a credit to the corporate sector( TRUE ). Such a measure would thus be very different from a tax cut because it would not lead to larger debt levels and thus should not lead to sustainability problems later on. Postponing the payment of corporate income tax would of course help only enterprises that make a profit, but this should be considered an advantage because it would mitigate the impact of the credit crunch for sound enterprises, i.e. those that deserve to be saved( TRUE ). Companies that did not pay corporate income tax because they were not able to turn a profit even during the boom would not benefit, but they are also the most likely ones to be insolvent anyway( GOOD IDEA ).

I disagree in only one respect, and that is that in Saver Countries you might well need the government to increase spending, and I believe that there are a number, although not unlimited, things that they could do, including simply increasing social safety net spending.

"But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed"

David Merkel on The Aleph Blog with a list:

"1) There are firsts for everything. Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952. America has always been a pro-debt and pro-debtor nation( SPENDER NATION ). It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period. But, the Pilgrims did extinguish the debt. Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity. With the decline in housing values, the fall in the ratio was inevitable. The low ratio puts downward pressure on home prices, because it means that more homes are underwater ( IT STILL HAS A GOOD SIDE ). Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector. Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more( TRUE ).

5) Now these same low yields whack Treasury money funds. How many will close? How many will cut fees? How many will break the buck, and credit negative interest? An unintended consequence of monetary policy. Another unintended consequence reduces liquidity in the repo markets. Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates( WHO KNOWS? ).

6) Brave Ben Bernanke is fighting the Depression. If his theories are right( I AGREE WITH BERNANKE ) (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy ( TRUE ). But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle( TRUE ).

7) Inflation is the lesser evil at this point.( I AGREE ) It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go( TOO MUCH ), and Elizabeth Warren now confirms it for the Treasury. My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.” So it is for the TARP bailout( A HYBRID ). Policy made hastily rarely works. Spend more time, get it right. The market won’t die as you work it out.

9) But will AIG die, or the automakers?

• Sales are slow for assets at AIG. ( THEY WILL BE. BUYERS CAN TAKE THEIR TIME ) (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
• And who knows where the writeoffs end? As I said long before the failure of AIG, don’t trust the financial statements ( TRUE ). The palce was too complex, and the culture of fear inhibited objective financial reporting.
• GM’s suppliers are seeking cash. Just one of the costs of financial stress.( WOULDN'T YOU )
  
• Suppliers worry over a lack of demand if the automakers fail. They should retool for Japanese and European automakers. ( MAYBE )
  
• From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway. I predict they will be back hat in hand in half a year even with a bailout( THEN WE CAN LET THEM FAIL ).
• A GM bankruptcy would take a long time, and a prepack would not get done before the cash runs out. Maybe, but I would still take it through bankruptcy, with the US Government as the DIP lender. ( THE BAILOUT NEEDS TO BE SEEN AS JUST THAT, BOTH FOR SOCIAL REASONS DEALING WITH PERCEPTIONS OF FINANCIAL TYPES BEING THE ONLY ONES SAVED, AND THE GOVERNMENT GUARANTEES ARE ESSENTIAL TO GETTING OUT OF THIS . THAT'S WHY INVESTORS ARE FLEEING AGENCIES FOR TRASURIES )
  

10) Even VCs are looking at the survivability of their portfolio holdings. Who can survive and become cash-flow positive in a tough environment. Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers. Watch the loan covenants, so that you can get good recoveries in a default. If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults. For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices. Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss. This is a tough time for anyone taking credit risk. That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics. I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers. He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes. ( I'VE BLOGGED ABOUT THIS POST )

16) You can give the banks funds, but you can’t make them lend. Would you lend if you didn’t have a lot of creditworthy borrowers? ( YOU CAN MAKE THEM LEND )

17) The export boom is dead, for now. Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed. Sorry, but the secret to changing the residential real estate market is not lowering interest rates( IT'S A WAY THAT THEY CAN BE SEEN AS HELPING HOME OWNERS ), but writing-off portions of loan balances. Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater. Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?( THAT'S A POSSIBLE SOLUTION )

19) On commercial property, when do you extend on a loan vs foreclosing? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan. More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position. With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now. (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever. Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming ( TRUE ). As the interest rate differentials narrow in real terms, the US Dollar should improve.( TRUE )

But, there are complicating factors. Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates. Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply ( TRUE ).

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies ( TRUE ). For now, put your macroeconomics books on the shelf, because they won’t be useful for some time ( TRUE ).

A good post.

"policies that do not bring the trade surplus down sharply are inevitably going to cause trade friction, and that is a game China cannot play."

Here's a post that links two of the major "Saver" Countries in their possible responses to a Stimulus. From Michael Pettis on China Financial Markets:

"Earlier this week Ambrose Evans-Pritchard had an article in the UK paper The Telegraph which starts off with “For the first time in my life, I am starting to feel twinges of anti-German sentiment.” The article goes on to lambaste the German government, and especially German finance minister Peer Steinbrück, for what Paul Krugman earlier called “boneheadedness” in refusing to participate in the European fiscal expansion and, worse, for calling British and French programs “crass Keynesianism.” According to Krugman:

The world economy is in a terrifying nosedive, visible everywhere. The high degree of European economic integration gives Germany a special strategic role right now, and Mr Steinbrück is doing a remarkable amount of damage. There’s a huge multiplier effect at work; it is multiplying the impact of German boneheadedness.

Evans-Pritchard explains why a number of European countries, led by France and England, are so angry:

Put bluntly, Germany is pursuing a beggar-thy-neighbour policy. It is not fulfilling its responsibilities as the world’s top exporter and pivotal power of Europe’s monetary union. It is leaching off global demand, even as it patronizes Anglo-Saxons, Latins, and Slavs. No doubt binge debtors in the Anglosphere are much to blame for this crisis. But Germany rode the boom too. It made those Porsches and BMWs driven by the new rich. Its banks are among the most leveraged in the world.

Nor should we not forget that the European Central Bank set interest rates at recklessly low levels early this decade to help Germany out of a slump. Can this be separated from the property bubbles in Club Med, Holland, Ireland, Scandinavia, and Eastern Europe now causing such grief? Within the EMU, Germany has gained a competitive edge against France, Italy, and Spain for year after year by screwing down wages. In pre-euro days the North-South rift did not matter. The D-Mark revalued. Balance was restored. In monetary union it is toxic.

The point he is making is that the imbalances were not created simply by “binge debtors in the Anglosphere” but also by those countries that subsidized directly or indirectly overproduction, which ultimately have had much to do with the very conditions that led to consumption binge. This includes not just Germany but any of the countries that created persistent and high trade surpluses ( THIS IS A VERSION OF MY QUOTE FROM DR. JOHNSON. THE LENDER AND BORROWER ARE BOTH AT FAULT ). Evans Pritchard makes the comparison very explicit:

Germany now has a current account surplus of 7pc of GDP. It is hollowing the industrial core of Latin Europe. Yes, Club Med needs to pull its socks up, but the flip side of the coin is that Germany is in breach of EMU’s implicit contract. The rules of the game are that surplus countries should boost demand. The Gold Standard collapsed in the early 1930s because they – then the US and France – refused to do so. The burden of adjustment fell on deficit states, who had to tighten yet harder.

The downward spiral dragged everybody into depression. Germany and China are today’s violators. Their trade surpluses over the last 12 months have been $283bn and $279bn, respectively. They are exporting excess capacity.

What does all this have to do with China? The reasons I bring this up is because it is, I think, a foretaste of the type of nasty battles that are likely to erupt between the trade-surplus ( SAVERS ) and trade-deficit countries ( SPENDERS ) as global demand continues to contract. The overconsuming trade-deficit countries cannot reduce their overconsumption except with a collapse in production (and sharply rising unemployment) if the overproducing countries do not also adjust. Furthermore, fiscal expansion aimed at generating employment in countries with large trade deficits will not be nearly as effective as they might be if they are not matched with programs in trade surplus countries (essentially demand boosting fiscal programs) that prevent domestic demand from bleeding out the trade account ( A VERY GOOD POINT ).

The French and the British (and much of the rest of Europe) are concerned that if their governments borrow to boost domestic demand and employment at home, they are also borrowing to boost demand and employment in Germany, which means that they bear the fiscal cost for the foreseeable future while Germany gets a substantial chunk of the benefit. This may be a great deal for Germany, but it is one hard for the rest of Europe to embrace.

In Europe it is clear to me that the economic debate is migrating rapidly towards consideration of the impact of trade, and it would be surprising if the debate does not quickly globalize ( TRUE ). If Europeans, nominally members of one country (sort of), can get into such an acrimonious debate among themselves, what hope is there for a polite and statesmanlike discussion that involves countries less tied together? I believe that in the US there is a much stronger commitment to free trade and, in spite of Mr. Bush, multilateral cooperation on economic issues, then elsewhere, but politics is politics, and rising unemployment in the US will inevitably lead to the same confrontational attitudes as they seem to have in Europe. ( VERY BAD )

By the way among the dozens of bankers, government officials, academics and businessmen I have met in the past few weeks to discuss trade issues, it seems to me that those of us who have spent the past several months warning about an imminent collapse in trade are getting more and more attention. This is undoubtedly going to become a hot issue next year.

It is not that China isn’t doing anything to address the problem. The slate of bad economic numbers this week and last (trade is down, we are racing towards deflation, investment and consumption growth is down, manufacturing output growth was only 5.4%, electricity consumption was down 8.6%) has confirmed what we all dreaded: things are slowing quickly. The government is trying to do all it can to boost the economy and, especially, employment, but I am afraid they still don’t understand their place in the global mayhem ( LIKE GERMANY ? ). They continue to see China as an innocent victim of the global crisis – not as one of the fundamental creators of the payments imbalance that led to the crisis – and much of their strategy seems to assume that China can adjust domestically without worrying about the impact on the global market. ( NOT LIKELY )

For example two days ago I was part of a panel that included a prominent Chinese economist and think tanker who I know and like very much, and as we discussed what needed to be done I got the impression that he hasn’t considered global implications at all (although as we discussed them he acknowledged many of my arguments). For example, much of his currency focus was on how China can retain export competitiveness without encouraging hot money outflows. But that is not the right way to think about it. China needs to think not only about the domestic impact of its currency but also about the global impact of its currency policy, and how that affects the adjustment that trade deficit countries are undergoing ( VERY GOOD POINT ). If it makes things worse for them, there is no reason to assume that they will remain indifferent to Chinese domestic policies, and there is even less reason that they will run policies that accommodate China’s needs.

China is making Herculean efforts to get out of this mess. It is doing everything it can to maintain growth and is clearly very worried about the pace of the slowdown. Bloomberg, for example, had this article today:" ( THEY TOO ARE PRAGMATISTS )

China’s government plans to lower taxes and reduce the lockup period for home sales to stem a decline in the nation’s property market. Home owners will be waived from paying a sales tax on properties sold after three years of purchase, compared with the previous term of five years, according to a statement today by the State Council, China’s cabinet. The tax will also be levied based on the profit from the sale, instead of the sale price, according to the announcement.

These are all good things because they are aimed at boosting domestic consumption, and to the extent they also affect production positively, they affect non-tradable goods. That is a start. But there must also be recognition that policies that do not bring the trade surplus down sharply are inevitably going to cause trade friction, and that is a game China cannot play. A collapse in trade would force a brutal adjustment here."

Read the rest.

I find this problem of getting the Saver Countries to spend a tough one.