Thursday, May 28, 2009
The first of these is that the balance of trade, and current account balances of the UK and US are still in negative territory. Rather than detail the situation as it stands, I will try to illustrate the profound problem this represents through a gross simplification. I hope I will be forgiven this method.
If we were to imagine a world in which there were only two trading countries, that their trade was confined to two products, and that their trade was undertaken as barter, we can strip out the complexities of currency, and see the underlying problem. For the example, we will imagine that one country exports packs of pharmaceutical pills, and the other country toys. In country A, they manufacture 100 packs of pills per day, with 100 workers manufacturing 1 packet of pills each per day. In country B, they manufacture 100 toys per day, with 200 workers producing half a toy each per day. The workers in country B are willing to exchange 1 toy for 1 packet of pills in barter exchange. As such, the productivity of country A is twice that of country B, implying that country A is by far the wealthier country.
The problem that then arises is as follows; Country A is consuming 80 packets of pills per day, but also consumes 40 toys per day. Furthermore, Country A is saving nothing, whilst Country B is saving some. In the table below, it is possible to see how, after five years of this arrangement, Country A owes country B a whole years labour per worker. I make no pretense that these are real figures, but they serve to illustrate principles ( I hope the table is clear, as Blogger shrinks the images down, which is very annoying). As a note the exchange value is 1 toy for one pack of pills, such that each represents 1 unit of output.
What we are looking at in this table is a country B with large numbers of workers, with low productivity, but relatively small consumption levels and a high savings rate overall. I have put a separate column for savings in the table, but the debt owed by country A is (of course) representative of savings. The point in having a separate column is just to emphasise that the individual consumers in country B are very thrifty and cautious, and they therefore hold back from committing all of their stored wealth as credit to Country A. In other words they keep a store of toys (money) ready for exchange in the event of emergency. The model only shows the export trading part of the economy, and this store of toys is there for the exchange of goods and services, but still represents stored value.
The purpose of the table is to show what happens when one country over-consumes, and another under-consumes. Despite the high productivity of Country A, they are still in deep, deep trouble. By seeing the trade in terms of barter rather than currency, it is apparent that it is labour that is being exchanged.
Typically, what we see is such ideas hidden under mountains of economic theory, and obscured by many complicating factors. However, if we look at trade in these simple terms, it is possible to see how, in the end, one worker ends up owing another worker a huge amount of their labour. In this scenario, each Country A worker owes country B an entire years worth of labour. When considering this, it is necessary to also factor in to the equation that no individual is able to actually give a year of their labour to repay debt, so this labour must be repaid over time. As such, of course, the labour that is providing the credit in goods would (and does) demand interest for foregoing the consumption that they might achieve now for future consumption.
The table does not therefore fully express the severity of the situation for country A.
If we apply such a principle to the real world, thinking of the US (like Country A) and China (like Country B) as obvious examples, it is possible to see that something, somehow, absolutely has to 'give'. If we remove the complications of currency, it is possible to see that there is huge amount of labour owed by the US to China. It is also possible to see that China has the savings that will allow it to ride through the current downturn. For real current account balance figures, the US can be found here, and China here.
Inevitably, life is not as neat as the illustrative example, but the principles are what really underpin the nature of trade. It is the exchange of labour between two countries, not the exchange of money. Money is just an intermediary that represents the equivalent of toys and packets of pills.
If we think of the world in terms of this underlying exchange of labour, then it becomes clear that the previous current account deficits of the US has put the economy very, very deep in debt. If we then view the ongoing current account deficits, then we can see that the problem is just getting worse, albeit at a slower rate. The US is confronted with choices, none of which are very palatable. The first choice is to accept the reality of the debts, and therefore do what is absolutely necessary. This is to live in a frugal way until the labour owed to China is repaid. This means, in practical terms, a significant decline in living standards, with a massive decline in consumption, as more of the value of labour is switched to exports. For China, this means that they would not have to work so hard to achieve the same living standard, or they might still work as hard and have a far higher living standard.
After all, if the US starts to use its labour to repay debts, then the value of that labour will flow into China in the form of goods and services.
It is at this point, that life gets somewhat more complicated. It is the question of how this might be achieved.
The simplified model ignored currency in order to illustrate the underlying principles of what has taken place in the world economy. However, the reality of the world is that it does have a currency system. The underlying problem that the US must confront is that, at current valuation of the $US (albeit it has fallen back recently), it can not compete with Chinese labour in many sectors (thus the ongoing deficits). This is a very curious situation.
What we currently have is a belief that the ongoing deficits and the existing debt of owed labour do not matter when considering the value of the $US. It is the only explanation of why the $US might be valued in the way that it is. In part, this is a result of a false confidence in the productive capacity of US workers and the US economy as a whole. Another part of the problem is that China has a nasty choice. The only way that they might be repaid for the labour owed by the US is to accept that part of the existing debt of labour owed be wiped off the slate. I will try to explain this difficult concept...
When Chinese labour was exchanged for promissory notes from the US, there was a belief that the US would eventually exchange the labour for the full value of the notes. The problem arises that, if the US were to make this exchange on the original terms, then US labour would be unable to exchange their labour for the products of Chinese labour. Quite simply, they owe too much of their labour, and repayment would mean that they are living in relative poverty. In short, their consumption would fall back to a degree where they would by buying very, very few goods and services. The Chinese economy is largely centred around provision of their labour to provide goods and services to the US economy, and the halting of the consumption in the US would leave many companies without a market.
Now if we return to the table example, it is apparent that the Chinese are very productive, but consume very little. They are cautious consumers. In order for the situation to be rectified, they need to consume more of their own output. In other words they need to live more wealthy lives. The trouble is that, for cultural and systemic reasons, they are cautious, and would rather not use their acquired wealth for immediate consumption. If they were to consume more of their output, then they would be in a position of living relatively wealthy lives, and this would be further bolstered by the repayment of the labour owed to China by the US.
The problem then arises as to what will happen to all the factories that have, in effect, been lending the labour to the US? If the US economy collapses, then there is no market for their goods. If they demand that the US repays the debt of labour owed (on the original terms) the US will be very poor, and will be unable to afford to buy any of the products of Chinese labour.
The Chinese are now in an uncomfortable position. It is apparent that the US would struggle to have its workers repay debt, and this would be a political nightmare to enact. Nobody likes to move from apparent wealth to actual relative poverty. As such, instead of accepting the underlying reality that is represented in the current account deficits, both the US and China are doing the equivalent of sticking their fingers in their ears and singing 'la, la, la, la!' at the top of their voices.
The real problem, however, is what the US is doing to try to rectify the problem. It is apparent that US labour has been doing the same as the country A workers in the table. They have been consuming more than they produce, and now owe significant amounts of their labour to China. Now that they are confronted with repayment of their debts, they simply do not want to pay. Furthermore, they are demanding that their ability to consume more than their output is continued.
The US government, rather than telling them the hard reality that it is repayment time, is telling them that they can, in fact, continue to consume more than they produce. In order to allow this to happen, they are using several rather dishonest measures. The first of these is that they are attempting (and currently succeeding) in persuading many countries, organisations and people, that the US is in a position to one day repay the debt of labour owed, and that the US has sufficient future output to repay even more debt to the labour of others in the future. The curious part of this is that, up to this point in time, they have offered no explanation of how the US might actually achieve such (increasingly massive) debt repayments.
The second measure that they are enacting is the policy of printing money, and the eventual devaluation of the $US. This is a measure to allow the US to default on the debts of the past. In the table, the barter exchange rate is 1 toy = 1 packet of pills. However, in the real world currency is an intermediary, and devaluation of the currency is a way of post hoc arranging that 1 toy = something like 0.6 packets of pills. In other words, they are reneging on their debt, and breaking their promise to pay.
Whilst this may resolve past debts through dishonest means, it still leaves the US with an underlying problem. The apparent wealth that they have enjoyed is, in part, due to living on the labour of others. However, if they do not repay their past debts, that labour will be withdrawn (e.g. if they devalue their currency, China will no longer lend their labour). At the time that the labour is withdrawn, the US will find that it is reliant upon the output of its own labour, and that labour is insufficient to support the standard of living that was possible with the labour input of countries like China. They will find that they are very much poorer than they imagined, and that is a painful situation to confront.
Perhaps this is too simplistic. I would welcome comments on the situation, and how the underlying premise might be wrong.
Having said all of this, it might appear that I am painting China as an innocent party in the current problems. However, as I have emphasised in the past, China has manipulated its currency in a policy of mercantilism. In so doing they have systemically under priced the value of their labour, and used this to ensure positive trade balances. The cost of this has been borne by Chinese workers, whose purchasing power of imported goods has been diminished, and whose earnings have not properly reflected the market value of their labour. For example, by holding the value of the RMB at an artificially low level, the cost of imported goods has been held high, meaning that each worker is relatively poorer than they might otherwise be. This has also had the effect of overpricing US labour, such that it is not competitive.
The result of such a policy is that China has protected its domestic manufacturers in the home market, and subsidised their exports through underpricing their labour. In so doing, they are making an investment in the future of China, as the result of the underpricing is that they are able to compete unfairly, by undercutting US companies and putting them out of business. I remember reading an article in the Economist a long while ago that suggested that a country in receipt of subsidised goods should be grateful that they are able to consume the products at a discounted rate. However, the result of such subsidy is to destroy businesses that might otherwise compete with such products.
What we can now see in the relationship between China and the US is a very messy situation. The US owes a huge amount of labour to China, and is unable to pay this debt without a massive retrenchment in consumption. That the US is not facing up to debt, and is increasing debt, is a problem that will simply not go away. Whilst US consumers are now starting the painful process of debt repayment, the government is increasing its debt to attempt to maintain living standards in the US. However, in doing so, the overall debt in labour owed to other countries is still increasing. This despite the fact that the US is both unwilling and unable to service existing debts as their economy is currently structured.
Meanwhile, China continues to under price its labour, and therefore continues to undercut the labour of the US, such that it continues the process of hollowing out US capacity to ever repay the debt. In doing so, it drives the US ever further into a ditch.
Quite simply, when we remove the complications of currency, and think of the debts owed by one country to another in terms of labour owed, the madness of the current situation becomes apparent. It is also possible to see that the actions of governments are quite simply making a very bad situation worse, and that the final outcome - or denouement of the situation - will be ever more extreme.
Note 1: I hope that all of this makes sense. I showed the post to another person before publication to see whether there were any errors in my thinking, and the response was very positive. I am aware that many readers of this blog are very astute, so I will also look to you to identify any problems in my thinking. My concern is that, when expressed this way, the gravity of the situation becomes so profoundly obvious, that I simply must be missing something. I look forward to the comments.
Note 2: I have had some interesting links that are pointing to increasingly negative sentiment for the $US. The link provided by Don Keyes is a good summary of the situation. Is this the start of the $US collapse? Quite possibly...but I have predicted the collapse before and been wrong. Like any sane person, I do not want to see a $US collapse. However, set against this, better sooner than later....the longer the US government and Federal Reserve follow their mad policy, the greater the long term damage to the US and world economy.
Thursday, May 21, 2009
In a recent post, I sought to understand why I had called the collapse too soon, and suggested that perhaps the mechanism was anchor prices, an idea proposed by Dan Ariely. Essentially, this is the idea that the first price we see anchors our price expectations, and I extended the idea to the value of economies. In one example, if I recall correctly, Dan Ariely identifies how DVD players started off very expensive, and how, as the price reduced, we had a sense that they were bargain prices - even though all DVDs were less expensive. We were still fixated on the original price, not the price now.
I raise this example as, one way or another, despite our natural tendency to anchor, prices do indeed fall. In the case of the Western economies, we are starting to see the shift in the perception of the value of the economies, though the 'stickiness' of the anchor is still there.
This brings me on to the news, which indicates that S&P have put the UK's rating to a negative outlook, a move that is often a precursor to a sovereign downgrade. I have long been waiting for the markets to 'get it', and have long been puzzled that it has taken them so long. However, this is not necessarily a reason to conclude that the 'end' is now nigh. A metaphor might express the situation, which is to see the anchored valuation of the UK economy as a dam, and this is an additional crack in the structure of the dam. Just as with a dam slowly developing cracks, with the structural integrity weakening with each new crack, it is hard to say which crack will finally result in the deluge.
In my discussion of the climax of the crash, I speculated that the £GB would be the first to fall, and that the $US would follow after. In saying this, I recognised the inherent stickiness in our valuations of economies, and saw a necessity of the £GB falling in order to create enough of a crack in the dam to see the $US fall:
From my point of view, it will be the collapse of the UK economy that will be needed to shatter the belief in the US economy, and will be the final impetus to push the $US over the edge. Such a collapse might even see a brief run to safety into the $US, before the realisation hits that it is a run into dangerWe have this quote from the Times, in which the latest US bank insolvency is discussed:
Investors were also concerned that the US may be next in the firing line after Standard & Poor’s sounded a warning about Britain’s AAA credit rating.What is happening is that doubts about the sustainability of both monetary and fiscal policy in the UK and US are steadily leaving ever more, and ever deeper, cracks in the dam. However, the belief that the US must come through this economic crisis remains, and therefore I still believe that only a £GB rout will finally destroy the $US. However, as the dam analogy makes clear, this is at best only a guess, as there are many other cracks that are appearing, and they might cumulatively be enough to burst the dam.
When I first started to suggest a $US collapse, I was probably seen by many as being a lunatic out on the fringe. The view of the fragility of the $US is increasingly spreading into mainstream thinking. I flicked through the headlines and conveniently found this article in the Financial Post:
The nature of the fragility of the $US is not, however, as simple as it might first appear. Another article perceptively highlights one of the underlying problems with the idea of a $US collapse, by pointing out that all of the major currencies are looking very 'ugly' at the moment:
The U.S. dollar's day of reckoning may be inching closer as its status as a safe-haven currency fades with every uptick in stocks and commodities and its potential risks - debt and inflation - are brought under a harsher spotlight.
Ashraf Laidi, chief market strategist at CMC Markets, said Wednesday a "serious case of dollar damage" was underway.
"We long warned about the day of reckoning for the dollar emerging at the next economic recovery," Mr. Laidi said in a note.
Mr. Laidi said economic recovery would weigh on the greenback as real demand for commodities, coupled with improved risk appetite, caused investors to seek higher yields in emerging markets and commodity currencies. This would draw investment away from the U.S. dollar, which was dragged down by growing debt and the risk quantitative easing would eventually spark a surge in inflation.
The British pound has been a beneficiary, rising on May 21 to a high against the dollar this year of $1.58. But a downgrade of the UK's outlook by Standard & Poor's has just taken the wind out of the pound's sails. The rating agency's assessment is a timely reminder that it is not just the US which is running a double-digit government deficit, doubling its debt in the space of a few years and praying that money printing - £125bn in the UK's case - will generate economic recovery.If we put ourselves in the mind of a scared investor, it is increasingly difficult to see where exactly we might want to place our wealth, such that it can be secured in these turbulent times. All of the major economies are in free fall, whether Europe, Japan, the UK or the US......What the investor is left with is the 'emerging market' economies, and these have traditionally been seen as the markets with the greatest risk.
The euro, too, has been winning admirers. Yet its previous chaste appeal - in the form of German opposition to money printing - has been tarnished a little by the European Central Bank's decision to buy E60bn of covered bonds. The ECB considered buying more than twice that, according to Bloomberg. That is hardly surprising given the eurozone's slump is so shockingly deep. The German economy shrank 6.7pc in the first quarter from a year before. The comparable dip in the US was 2.6pc. Now which currency is the ugliest of them all? [emphasis added]
On the one hand we have the high anchor valuation of the traditional leading economies, and on the other we have the risks associated with the emerging markets. It is no wonder that the signals from financial markets are so confused.
Added into this mix, we must also factor in the extraordinary actions of the Western governments, in particular the policy of Quantitative Easing (QE, or printing money). The UK and US are both embarked upon this policy, both countries are using the policy to support their bond markets, and both countries are steadily expanding the policy. The major overseas purchasers of the bonds are now becoming increasingly restless, and suspicious that the policy is going to lead to an inflationary default on debt, as is highlighted in a recent article:
For now, the dollar doesn't appear to have anything going for it. The US Federal Reserve has cut its benchmark interest rate virtually to zero. Worse, it is printing money and using the freshly minted cash to buy US Treasuries. The Chinese, the US's biggest foreign creditor, have made it quite clear that they take a dim view of this "policy mistake", as China's central bank put it. Undeterred by eastern frowns, some Fed governors have been gunning for even more money creation to buy bonds, according to the minutes of the last Federal Reserve meeting.Just to add to the toxic mix of Western policy, the EU has also started down the road of QE, though as yet they are not buying EU government debt with their freshly printed money. However, for the UK and US, overseas creditors are increasingly worried about the credit worthiness of the countries. The negative report from S&P is an indicator of the worries for the UK, but the signs are also not positive for the US. Russia is now shifting reserves into Euros, The Democratic Party in Japan is threatening to only purchase US debt denominated in Yen (making funding of US debt a Japanese election issue), and China is shifting its mass of $US debt into short term instruments out of fear of US inflationary policy.
However, the policy of QE, rock bottom interest rates, and massive government borrowing and spending might be enough to prevent the real collapse in the economies in the very short term. As I have often pointed out, this is a short term fix with very high long term costs. As such, for domestic purposes these policies may serve the politicians in the short term, but only at the price of destabilising their ability to raise finance in the future, and even greater general economic damage later. This is at the heart of the worries of overseas creditors.
One of the arguments that has, in the past, been provided for the stability of the $US was the reserve status of the currency. Even this foundation for the $US is increasingly being questioned, and I have long been writing about the many activities of China in which they are gradually positioning the RMB as the replacement reserve currency. A search on Google news produced a flood of articles on the subject, of which the following is just one example:
Once again, my early posts on the subject might have been seen as the ravings of a lunatic, but nevertheless the idea of an RMB reserve currency is gaining increasing credibility. The only difference now between myself and many commentators is that they see the shift as being long term, whereas I see it as a rapidly accelerating process. I suspect that the difference lies in the fact that they are not recognising the vulnerability of the $US, and that if the $US does collapse, it will not be able to retain reserve status. In other words, they are focusing too much on the RMB's growing strength, rather than the inherent weakness in the $US.
May 15 (Bloomberg) -- The yuan may gain as much as 5 percent against the dollar this year as China promotes wider use of the currency, according to Bosera Asset Management Co., the nation’s second-largest fund company.
China has signed 650 billion yuan ($95 billion) of foreign- exchange swap agreements in the past six months with countries including South Korea, Argentina and Belarus and plans to promote the use of the currency in cross-border trade. The renminbi may become one of the world’s three major currencies within 30 years, joining the dollar and the euro, Li Quan, executive vice president of Bosera, said in a telephone interview yesterday.
“Demand for yuan-denominated assets will grow as China is trying to make the yuan a global currency,” said Shenzhen-based Li, whose firm oversees 178 billon yuan of assets. “At the same time, concern about dollar devaluation will prompt investors to inject more capital into emerging markets, especially China.”
What all of this amounts to is that the shift in the shape of the world economy is slowly becoming visible in financial markets.
However, this is not the whole story.
One of the other points that I have previously discussed in the blog is that the world economy is pointing in the wrong direction, which is towards illusory wealth of Western consumers. I have suggested that, in order for recovery to take place, account must be made for the shift in wealth around the world. In a recent article for the Trade and Forfaiting Review, I used the Tata Nano and the US car industry as an illustration of how the movement of wealth will shift economic structures:
The important point about the Tata Nano is that it is meeting a new demand from a rising middle class in emerging economies. In the interim, the credit-fuelled demand for SUVs, the mainstay ofSince writing the article, I saw another article in which the shift in the structure of the world economy is already becoming apparent:
car industry profits (until recently), is collapsing. On the one side there is a car that rests upon an unsustainable credit-fuelled consumption boom, a car that flattered the aspirations of the indebted, and on the other there is a car that meets the rising aspirations of the world’s new wealth generators. US
I have long argued that the financial crisis is a symptom, not the cause of the underlying economic crisis, and it becomes ever more apparent that this is the case. The boom in house prices and credit bubbles simply masked a more profound underlying change, whilst magnifying the consequences. Whatever happened, the wealth was shifting to countries like China, but the indebtedness of the Western economies has made the change more devastating, and also has hobbled the ability of the West to recover.
General Electric yesterday became the latest big manufacturer forced to change course and make cheaper and simpler products to cope with the decline in purchasing power around the world.
The US engineering and financial conglomerate, which makes medical scanners, joins companies such as Sony and Unilever in seeking to develop less complex, better value products that will tempt customers in the face of the global recession. The shift away from cutting-edge technology and premium brands towards value for money is affecting a broad swath of businesses, from medical diagnostic equipment to soap powder.
GE is moving billions of dollars in research funds away from developing high-specification medical equipment towards lower-cost technology. Over the next six years GE Healthcare will devote half its $1 billion R&D budget towards low-cost products designed for use in emerging markets and remote areas, up from only 15 per cent today, John Rice, GE’s vice-president, said.
In the meantime, the governments of the Western world are seeking to sustain an economic 'shape' that was itself a product of an illusion. The change in the shape of the world economy has already taken place, and is just now become clear to see. As the illusion is dissipating, the world, the markets and individuals are starting to see the underlying reality. It is primarily the governments of the West that still seek to persuade us that we are in the illusory world that has already passed from existence, and seek to persuade us that it is still within reach. It is an illusion that flatters our dreams and aspirations, and is therefore an illusion that is aimed at a receptive audience. It is pushing at an open door.....we want to believe....
An interesting comparison again comes from Dan Ariely in a lecture that he gave recently (see video here). He shows a picture of two tables, where the length of the tables is an optical illusion in which one looks longer than the other - but they are in reality both the same length. Even having demonstrated that the tables are the same length, we can not help but still see one table as longer than the other. If you see the image below, it is possible to see the illusion in action. I can tell you that the tables are the same length, but still they appear to be different (image from here)
We have a resistance to seeing reality.
Even when we are told something is real, we can not help but hold on to our original perceptions. Whether the length of the tables, or our anchor valuation of the economy, we are sometimes resistant to abandoning our previous perceptions.
As we look on at the shift in the world economy, it is possible to see how enduring the illusions are. Even as ever more evidence mounts to suggest that we are witnessing a different shape, still we cling to the illusory world of old. We are still insistent upon the illusion that the West is still wealthy, that one way or another, it simply must be. Every day another measure tells us that the size of the economy is an illusion, but still our perceptions revert back to the illusory size.
The problem is that reality is still reality. Just as we must accept the reality that the tables are the same size, so must we accept the real size of our economies. It is this wilful disregard of reality that is, in part, driving us ever deeper into the ditch. I suspect that many in government have started to grasp the reality, but they are clinging on to and promoting the illusion, if only for their own selfish ends.
The underlying purpose of this blog has been quite simple. I have sought at every stage to paint a picture of the underlying reality of our economic situation. In doing so, at many stages, I am sure that I have been seen as raving, of being an 'end is nigh' doomster. The trouble that arises is that, as the economic crisis progresses through each stage, the scale of the disaster is becoming increasingly evident. What might have been viewed as ravings of a doomster eventually creep into the mainstream. Whilst getting some points wrong, the general thrust of the thesis of the blog appears to be correct.
The thesis is that the West is not, and will not be, as wealthy as it thought. A major change has taken place, and there is no prospect of reversing that change. Western governments, with their profligate interventions, are simply denying the world that sits before them. In denying reality, they are simply pushing the decline ever further, and to a point where any recovery of our former wealth becomes ever more impossible.
As with any other commentator on the economy, perhaps I am also subject to illusions, and might be perceiving an illusory world. The trouble is that, as time has progressed forwards, the world looks ever closer to the one in my perceptions. It is not a heartening thought.....
Some responses to comments on the last post.....
Jonny, in response to your question about how the Bank of England might cause deflation in the RPI, perhaps the BoE February inflation report will clarify. I hope this is the right report, but they point to lower interest rates impacting upon the RPI. I was going to quote from the report, but my Internet connection has gone into a tailspin, such that it is very slow today (rather frustrating...). Apologies for not being able to offer up the quote (assuming I have the right publication and date).
Anon82, I think that you will find that my post on the US economy may shatter any illusions of any significant recovery. Many of the points might apply to the UK economy.
Gingellenator, I have discussed the inflationary default for a long time across many posts. I would like to provide you with a link, but this is an argument that has evolved through several posts. As such, time allowing, I might pull the thoughts together at a later date.
Sobers, you are quite right to question how QE might be reversed. You might note that there are no credible or serious plans for this, just vague assurances. It is hardly comforting.....
Anonymous, on the subject of the Bloomberg house price article. I am very impressed with your dilligence, and am unsuprised to find that yet another positive indicator is not at all positive.....For curious readers, you may want to compare and contrast the following two articles:
Adam, thanks for the Austrian view on inflation, which is an interesting contribution, in particular as it is so relevant to the post.
Clauswitz, thank you for your kind comments.
Kecske, thanks for the link to the article on hyper-inflation. I had picked this one up on Reddit. It is certainly interesting, but I have some reservations. I would like to discuss these, and may come back to it in the next post that is relevant.
Anonymous and Anonymous82, many thanks for the links on the S&P downgrade....very useful.
Tuesday, May 19, 2009
It becomes increasingly difficult to view such articles without a measure of irritation developing. In particular, the media seem to be subject to some confusion. As such, a quick introduction is given below to the two main measures of inflation, taken from National Statistics (emphasis added):
Deflation tightened its grip on the economy last month after a record fall in retail prices.
The retail prices index (RPI), the benchmark for pay deals, fell to -1.2 per cent, the lowest since records began in 1948, dragged down by a decline in energy and mortgage costs.
Economists expect that prices may fall farther as the recession takes its toll and unemployment rises. Some believe that the rate could fall to about -2.7 per cent, raising fears of prolonged deflation as consumers delay purchases and businesses withhold investment.
Consumer Prices Index (CPI)
The Consumer Prices Index (CPI) has been designed as a macro-economic measure of consumer price inflation and forms the basis for the Government's inflation target that the Bank of England's Monetary Policy Committee is required to achieve. It has been developed according to internationally agreed rules and internationally is known as the HICP. The HICP is the preferred measure for international comparisons of inflation.
Like the RPI, the CPI measures the average change from month to month in the prices of consumer goods and services. However it differs in the particular households it represents, the range of goods and services included, and the way the index is constructed.
Retail Prices Index (RPI)The important point to note here is the key difference between the two measures, which is in the cost of housing, as follows:
The Retail Prices Index is the most familiar general purpose domestic measure of inflation in the United Kingdom and is continuously available from June 1947. It measures the average change from month to month in the prices of goods and services purchased by most households in the United Kingdom. The RPI or its derivatives are used by the Government for the uprating of pensions and benefits and index-linked gilts.
For example, the RPI basket includes a number of items chosen to represent owner-occupier housing costs, including mortgage interest payments and depreciation costs, all of which are excluded from the CPI. These differences are described in greater detail in Roe, D. and Fenwick, D. (2004), ‘The New Inflation target: the Statistical Perspective’. Beyond these specific areas, the contents of the CPI and RPI baskets are very similar, although the precise weights attached to the individual items in each index differ [the Roe and Fenwick article can be found here]It is very easy to get these measures confused, but the important point to take forward is this:
The government and Bank of England use the CPI for inflation targets, and the CPI does not include housing costs.
By contrast, the RPI includes housing costs as follows, taken from the ONS guide here:
RentBack in December, I wrote a post on what I thought the prospects were for deflation, and pointed out that currency weaknesses and therefore higher import prices would likely offset the deflationary factors within the UK economy. At the time of writing, food prices were already starting to climb. As it is, much as predicted, the CPI has continued to be inflationary. The chart below shows the different measures of inflation.
Private furnished rent Private unfurnished rent
Local authority rent Registered Social Landlord (RSL) rent
Mortgage interest payments
Average interest payments on a typical repayment mortgage (estimated/modelled)
[Chart from the ONS here]
Having introduced these measures, the astute reader will immediately see that there is a circularity to the measures. Mortgage interest payments are linked to the interest rate, and the interest rate is determined in part by the interest rate targeted by the central bank. As such, during the boom years, the RPI would have been held down due to the low level of measured inflation of the CPI. In other words, even though there was rampant inflation in the economy (in house prices), it was hidden in part by the way in which the statistics were used and measured.
It is here that we come to the source of irritation. At present, the Bank of England have reduced interest rates to record lows. As such, the cost of servicing mortgages and indirectly rental costs are falling. Furthermore, as house prices fall, there will be a combination of lower interest rates on smaller mortgages. In this scenario, the problem is that what we are seeing is a case of deflation being measured as a result of an asset price bubble popping, and central bank intervention.
It is hard to imagine that the asset price bubble bursting should be seen as a bad thing, as it is an inevitable correction in the market. As for the other element, the central bank intervention, this is where the circularity starts to kick in - sort of.....If we remember, the bank targets CPI, not RPI. However, in the Bank of England inflation report from February, it might be noted that the RPI is discussed in the report, even though the CPI is the target for inflation. You will note how the measures are blurred in this passage.
Deflation is sometimes used to describe any fall in the general level of prices (as measured in the United Kingdom by the CPI, RPI or the GDP deflator), however short-lived. A more economically significant phenomenon, however, would be a sustained period of negative inflation.Whilst there is no direct statement of targeting of RPI, the way in which the whole passage is put is somewhat grey. The same section of the report then goes on to warn of the dangers of deflation......it appears that the Bank of England is subtly conflating the two measures, and they even use a chart which is designated as the 'ONS composite index'. (p33) One of the interesting points is that an argument for printing money directly follows this discussion of RPI and deflation:
The RPI is likely to fall temporarily over the coming months (Section 4.1). This period of negative retail price inflation would be unusual (Chart A) and predominantly reflects the much lower contribution from mortgage interest payments, following the recent large falls in Bank Rate. The MPC’s central projection is for its target measure, annual CPI inflation, to remain above zero throughout the forecast horizon. (p33)
Periods of low inflation, associated with weak demand, may limit a central bank’s ability to use conventional monetary policy to stabilise the economy. But if reductions in official interest rates do not prove sufficient to meet the inflation target, policymakers still have other options available to them to stimulate the economy, if necessary (see the box on pages 44–45 in this Report). (p33)Page 44-45 are discussions of unconventional monetary tools, otherwise known as quantitative easing (QE- or printing money). The problem that we are now seeing is best expressed by Liam Halligan from the Telegraph:
Liam Halligan is quite correct that the latest report passes by the deflationary scare stories, and rightly identifies that there was no real prospect of CPI deflation. As can be seen from the chart earlier in the post, it is still relatively high. However, he misses the way in which the RPI was introduced as a means of pulling deflation into the picture in the February report. As you will see from the above text, it is done in a very subtle way, and this has been broadly absorbed by most of the media. The elements of the report that considered CPI were very nuanced, and were not firmly deflationary.
Over the last few months, we've printed money on an unprecedented scale and run up enormous extra liabilities. When sensible people have protested, pointing out the clear dangers, we've been told such "bold" measures were necessary for the UK to avoid getting sucked into a deflationary spiral.
But now, just three months later, this looming threat has apparently passed. It warrants not a mention in the Bank's Inflation Report. Has deflation really gone away? Or did we never actually face such dangers? Was the spectre of deflation conjured up, instead, for other reasons – as an excuse for this ghastly Government to yank monetary policy back off the Bank and nail interest rates to the floor, while junking fiscal caution and borrowing in a fashion more akin to a banana republic?
The February report was actually a very subtle and nuanced document overall. The spectre of deflation was primarily raised against the RPI, but the way that the report reads does not reflect this. Crucially, acceptance of the deflation argument was the reason for why quantitative easing (QE - printing money) was accepted in the media. Now that the controversy over QE has died down, the RPI issue is now quietly dropped, along with the talk of deflation.
Here is the central problem for the Bank of England. The only way to justify QE is through the fear of deflation, but the only measure that is showing deflation is the RPI. The bank's remit does not extend to RPI so that it can not use the RPI as an excuse to print money. As such, they subtly conflated the measures, planted the idea of deflation in the mind of the media, and 'lo and behold', deflation has appeared. It now looks like, post hoc, that the Bank of England can justify the deflationary scare. Through smoke and mirrors, the media have accepted the deflationary argument and continue to accept QE.
However, if the media were paying attention, they would note that the deflation is on RPI and, in part, due to the very policies that the Bank of England is actually pursuing. In particular, the Bank of England is fighting to reduce interest rates on consumer debt and mortgages through QE and historically low interest rate policies. Furthermore, the deflation of the housing bubble, in which asset prices are returning to sustainable levels, would be an extremely difficult reason to use to justify the policy of QE - if not impossible. Such an argument would be that the policy is aimed at reflating house prices, and I am not sure that anyone in their right mind might accept such a policy.
The fundamental problem in this whole picture is that the Bank of England has a problem with justifying QE if deflation is identified in the RPI. Over and above the problem that the remit is to target the CPI, the problem arises that targeting of the RPI would be to reverse a bubble deflating and would also preclude any further monetary easing. In particular, the monetary easing would serve to reduce interest rates, and thereby be deflationary through reduced costs in housing.....
I am hoping that, at this stage, it is apparent that there is a significant problem with the policy of QE. The remit of the bank is to target the CPI, the justification for QE is deflation, the index showing deflation is the RPI, and the bank is actually contributing to deflation in the RPI.
In other words, even if the principle of QE is accepted (which is not the case for this blog), there is currently no justification for the policy which can withstand scrutiny. Under such circumstances, it is only possible to return to the long standing argument/theory of the blog, and conclude that QE is simply a way of printing money to buy bonds and support the bond market. The policy is therefore really about printing money to support profligate government spending through printing money.
The trouble is that, excepting a few commentators like Liam Halligan, the media are still buying the lie that QE is to fight deflation.....
I did not want to make the main article too long, so I have not discussed the problems with deflation theory. I discussed this in a very long post previously, and have quoted from the post below [the most relevant bit]:
Economists say that deflation is a terrible thing. They say that it wrecks economies. If you have deflation, then people stop consuming, and stop investing.....
Let's start with the case of consumers stopping consuming. In this case, we have a good example of deflation to illustrate that deflation does not stop people buying things that they want. The example is computers which, as every year has gone by, have become ever cheaper in relation to their performance and sophistication. We all know that if we wait until next year, we will get a much better computer for our money. This is real deflation, but during a period of real deflation, the sales of computers has expanded, and expanded, and expanded.
If we think of a more mundane example, we might come up with something like a bottle of shampoo. Let's imagine that every year there are ongoing productivity gains in manufacturing shampoo such that the price falls by 3% per year. Does this mean that we will defer our buying of shampoo? Does that mean that, in order to benefit from the price reduction of shampoo, we will walk around with greasy hair.
Alternatively, we can take the case of a discretionary spend on something like a holiday. As some people will be aware, the low cost airlines have seen huge reductions in the cost of overseas travel, and the costs continued to go down over a period of years. Did this mean that people stopped overseas travel while they waited for the flight prices to drop even lower? What we actually saw in places like the UK was a massive expansion in overseas travel, as it became ever more affordable. However, this occurred despite deflating prices. This is like the example of the wine glasses....
The idea that people will not spend money during deflation is simply not true. However, if we knew that there was an unusual deflation about to take place, such that we expected the price of something to drop dramatically at some future point, we might defer our spending. For example, if the newspapers were to announce that in April of this year that there will be a new type of computer which will cost half the price of a computer today, then we would likely wait until April before buying a new computer. Moreover, when the new computers were released in April, then the sales of computers would increase as more people could afford them, and we would all potentially be richer by a factor of half a computer (if that makes sense).
However, such events would always be exceptions, and we readily buy computers despite the steady price deflation.
In short, steady deflation does not stop people from consuming.
I have since seen a book review, on the Mises institute website, that uses similar arguments and examples. I was hoping to link to it, but could not find the article (apologies).
The other nasty element proposed for deflation is discussed in the Economist:
Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.However, this does not account for the savers. People who save see the value of their money grow, and this means that they have greater spending power. The problem is, of course, that there are too many debtors rather than savers....but this is perverse way of looking at the problem. A more balanced economy would not see such a situation, and it is lax monetary policy that caused the problem in the first place.
However, I do not want to go into the full argument here. I detail far more in the original post, and (bear with it) this can be found here. The issue of inflation versus deflation is very complex, and I am not sure that even my long article does the subject full justice.
I have long been grumbling about the use of inflation statistics. It has been a regular feature of the blog. Two quotes are given below, but these are only a limited selection.
This is from a post I wrote in January.
Now the expression measured is very important, because asset price inflation did not count in official inflation. In particular, as fast as new money was produced, asset prices such as houses inflated. Greenspan, in his wisdom, allowed one bubble after another to soak up the expansion in money. However, we have now gone one bubble too far, and there is no new bubble on the horizon to soak up the money being dropped into the market (which would in any case just be a delay, not something that would be a 'good' thing). As such, one of the sources of money absorption has been bubbles in assets, which stopped the prices of other goods going up. Mainstream economists seem to think inflation was conquered, but it was just displaced into something that was not measured.This is from a post in February:
It should be recognised that arguments against including house prices might be put forward, such as the idea that the cost of owning a house is in part dependent on the interest rates charged on mortgages, and that is a valid measure. However, this becomes a circular argument as, if house prices are inflating and are not measured in inflation, interest rates will remain low despite the actual inflation, thereby keeping the cost of the mortgage repayments relatively low whilst the asset price inflates. However you look at it, having to borrow £200,000 this year to by a house, and having to borrow £300,000 next year is inflation. The day to day cost of servicing the loan may change, but the cost of the good has still inflated.Note 3:
You will find the UK Office of National Statistics personal inflation calculator here. You will note that they do not calculate the rate of inflation by the interest rate paid on borrowing when buying, for example, household goods. They measure it against the price of the good itself. It seems that they have not noticed that a house is a 'good', or more likely they have decided that the inflation of house prices is something they would rather not measure.
For US readers, you may be interested in an article here. It details how the inflation statistics have been manipulated in the US. It is not happy reading. I have yet to find a similar discussion of UK statistics, and would ideally like to look into this. I did consider it, but will admit to being 'outfaced' by the scale of the problem of digging through the various papers, and studying the methodology in enough depth. Any links to such articles would be appreciated.....
I hope the above article makes sense still. I had to chop it around to shorten it, and hope that this has not led to any errors. Comment if you spot any, and any other readers can then see any errors.
Sorry to not respond to any of the comments, but this post was rather demanding of time. The final article does not reflect all of the articles I have recently read on the subject...as there are just too many out there....
I have long been (against the grain of the same conventional economists that failed to predict the recession) arguing that regulation of the banking system was a major part of the crisis. I have been heartened to see a very similar argument from Niall Ferguson, which can be found in the New York Times here....
Regular readers will know that I have long been discussing the idea that China has been positioning the RMB as the new reserve currency. Arguably, progress in that direction can be seen in Brazil, and more and more people are picking up on it:
The really interesting step will be any move towards pricing oil in RMB. My guess is that we are on the cusp of such a move, though initially it will be small scale (i.e. not the Gulf states). However, it is possible to see the progression forwards of the RMb with each passing week.....
Brazilian President Lula is the latest world leader (after Wen Jiabao and Vladimir Putin) to call for moving away from the US dollar in trade and and for a new monetary and financial order. On the eve of his trip to China this week, Lula suggested in an interview with Caijing (and other news sources) that the two countries should conduct more of their trade in their own currencies rather than the US dollar.
“Between Brazil and China, we need to establish a trade that is paid for in our own currencies. We don't need dollars. Why do two important countries like China and Brazil have to use the dollar as a reference, instead of our own currencies? We've already started doing this with Argentina. Our trade is taking place in our own currencies. Otherwise, we'll be in an absurd situation, where the country that caused this crisis will be the country that gets the most dollars. It's crazy that the dollar is the reference, and that you give a single country the power to print that currency. We need to give greater value to the Chinese and Brazilian currencies.”
Early this year, China supplanted the U.S. to become Brazil’s largest trading partner, as its commodity demands resumed and Brazil’s trade with the U.S. slumped. At the moment, Brazil is one of the few countries with which China runs a significant deficit which rose to $11 billion for all of 2008. Chinese imports are almost all raw materials.
Greater use of the RMB in trade with Brazil would be yet another step China has recently taken to increase the use of the RMB outside of China. China has been signing 3-yr RMB/local currency swaps with a range of emerging and frontier markets including Argentina, Brazil’s neighbor. As Nouriel Roubini notes in a recent oped, these swaps are small steps towards a possible greater international role of the RMB – pilot projects to use RMB as a settlement currency in Hong Kong Macau and Asean are other such steps. These deals are also another way to provide a bit of trade finance to key trading partners. The swap with Argentina might help finance China’s extensive trade with the country. As a result, even if US dollars are not used, it could well be the RMB and not the BRL that is used, especially if China wanted to avoid bearing the exchange rate risk.
In addition to the Petrobras-CDB deal the Brazilian development bank BNDES is reportedly seeking a credit line from China. BNDES, like other trade credit providers globally, has taken on a higher profile in the face of the withdrawal of private trade finance. Such a loan could be conducted in RMB/BRL. While that would be major, there are significant preconditions before the RMB internationalization progresses further. In particular, the more the RMB is used outside of China’s border the less control the central bank has. In this way China’s shorter-term goals of economic stabilization and longer term goal of more sustainable consumption driven growth may conflict.
Friday, May 15, 2009
The original article has been copied from the Zero Hedge website, and is reproduced below. The version on Zero Hedge, from my recollection, is an accurate copy of the original article. Zero Hedge suggests that the Telegraph article was taken down in response to a complaint from Mr. Patterson, whose views are the central point of the article, and who is now disputing that he said the things for which he has been quoted. Zero Hedge are now asking for the views of other individuals who were at the conference at which Mr. Patterson spoke, and the discussion of this can be found here.
I am reproducing the disputed article as I believe that it, if it does represent Mr. Patterson's views accurately, then it should be widely available. However, on reading the article, readers should be aware that the article is disputed by the subject of the article. The article follows below (I believe that the emphasis such as bold text has been added since the original article was published):
US 'sham' bank bail-outs enrich speculators, says buy-out chief Mark PattersonAt present there is no way to confirm that this was what Mr. Patterson said, and readers will need to consider this in whether they take the article seriously. However, there are a couple of points with regards to the article that might need highlighting. The first is that it is difficult to imagine any reasonable motive for why the reporter might have invented the quotes. After all, the article is based upon a conference where many people would have heard Mr. Patterson's discussion - and inventing things from such an event would therefore be an odd thing to do.
The US Treasury’s effort to stabilise the banking system through the TARP programme is a hopelessly ill-conceived policy that enriches speculators at public expense, according to the buy-out firm supposed to be pioneering the joint public-private bank rescues.
“The taxpayers ought to know that we are in effect receiving a subsidy. They put in 40pc of the money but get little of the equity upside,” said Mark Patterson, chairman of MatlinPatterson Advisers.
The comments are likely to infuriate Tim Geithner, the US Treasury Secretary, because MatlinPatterson took advantage of the TARP’s matching funds to buy Flagstar Bancorp in Michigan. His confession appears to validate concerns that the bail-out strategy is geared towards Wall Street.Under the convoluted deal agreed earlier this year, MatlinPatterson has come to own 80pc of the shares while the US government has ended up with under 10pc.
Mr Patterson said the US Treasury is out of its depth and seems to be trying to put off drastic action by pretending that the banking system is still viable.
“It’s a sham. The banks are insolvent. The US government is trying to sedate the public because they are down to the last $100bn (£66bn) of the $700bn TARP funds. They think they’re doing this for the greater good of society,” he said, speaking at the Qatar Global Investment Forum.
Mr Patterson said it would be better for the US to bite the bullet as Britain has done, accepting that crippled lenders must be nationalised. “At least the British are not hiding the bail-out,” he said.
MatlinPatterson said private equity and hedge funds were deluding themselves in hoping to go back to business as usual after the trauma of the last 18 months.
“This is not a normal recession and there will be no V-shaped recovery. The crisis has destroyed leveraged companies. We’re going to see a catastrophic increase in the number of LBO’s (leveraged buyouts) going into default because they’re knee-deep in debt and no solution exists since they can’t refinance,” he said.
“Alfa hedge funds have been making their money by gambling with excessive leverage, so the knife that cuts off leverage is going to cut off their heads as well,” he said.
Like many bears, Mr Patterson expects the great crunch to end in deliberate inflation, deemed a lesser evil than outright depression.
“The US government has thrown 29pc of GDP at this crisis compared to 8pc in the early 1930s. The Fed’s balance sheet has risen from $900bn to $2.7 trillion to bail out the system. America has to do it because the only way out is to debase the currency, but that is going to lead to some very high inflation three years down the road,” he said.
Matlin Patterson, however, has missed the Spring rebound, the most powerful rise in equities in over 70 years. “We shorted the equity rally because we thought it was lunatic. We’ve kept adding positions seven times, and we’re still holding,” he said. Ouch!
The second point to consider is that, if he said such things, Mr. Patterson would have risked any further involvement in bailouts and may have damaged the position of his company in any future bailout activity (Ratner calling his company's jewellery 'crap' comes to mind as a similar example). As such, retraction of the comments might be seen as an exercise in damage limitation, if the comments were indeed accurately recorded.
Neither of these points demonstrate that the article has accurately represented Mr. Patterson, but they are points that might be considered in making a judgement about the veracity of the article. I will, of course, field any comments on this from Mr. Patterson, and an explanation of why the original article is wrong, and why he has chosen to ask the article to be removed from the Telegraph.
In the meantime, I am guessing that many US taxpayers might find the alleged comments made by Mr. Patterson to be a matter of some concern. No doubt, many of these taxpayers might want to establish whether the comments were made and, if they were made, may find that their perspective on the various bailouts has shifted.
From the point of view of this blog, there is nothing new in the quoted comments and, if they are accurate, just serve to confirm an existing view. Of particular note is the comment suggesting that the banks are insolvent, a point made many times on this blog.
As a final comment, all credit to Zero Hedge for hanging on to the original article, and their efforts to establish the truth of what was, and was not, said. If such comments were made, they represent an 'insider' view that should be heard.
Thursday, May 14, 2009
- April 2009, China as the World Economic Power?
- April 2009, The RMB as the Reserve Currency
- March 2009, Economics and Power, the Loss of US Power
- March 2009, China, Gold and the $US
- February 2009, China's Pivotal Role in the Next Step for the World Economy
- January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
Even before these more recent articles, I have been reviewing China and the Chinese economy. In particular, I have highlighted the risks and the potential upside for China of the quasi-mercantilist strategy that has been pursued by the country.
- January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
- August 2008, China Propping up the $US
- July 2008, China - What Future?
Each of the stories above, taken in isolation, would not cause undue alarm. However, when considering them all together, then there is a worrying pattern emerging. It should also be remembered that all of the above are just examples. What is very clear is that China, and the Chinese government, are actively pursuing a policy of unfair trade at home and abroad. Quite simply, they are using economics as a tool of power rather than just enrichment.The point in linking to, and asking readers to review these articles, is to highlight the progressive nature of my argument, as well as giving readers an opportunity to review the considerable evidence for a deliberate bid for economic power by China. However, there is much else on the subject of China included in more general posts and too many to detail here.
I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.
As it is, it appears that the mainstream analysts are starting to understand what is actually taking place.
One example article can be found in the Business Spectator (I first saw the article in the FT). The thesis proposed in the article is that London and New York have a serious new competitor in the emergence of 'ShangKong', a concatenation of the names Shanghai and Hong Kong. The author points to the simple financial system in China as a virtue, before suggesting Shangkong as the new world financial centre:
How could China make a big, dramatic leap? It could begin by strengthening the links between Hong Kong and Shanghai, and transferring financial know-how from the former colony. The two cities are 750 miles apart, not an insurmountable distance in this age of rapid transit and internet communications. The connections are already being made: Beijing has just declared that Shanghai will be a major global financial centre in the next decade and co-operation between Hong Kong and Shanghai is growing, as shown by recent agreements to work together between key exchanges in both cities. Beijing could declare that Shanghai and Hong Kong will have a common set of regulations and recruit some of the world’s best financiers to bolster its regulatory structures – perhaps luring them with an advantageous tax regime no longer possible in the west.The author, Jeffrey Garton, is from the Yale School of management, which means that this is a perspective from an academic. As many readers will be aware, the academic community has had a very poor record in understanding the current crisis, with many acting as cheer leaders in the preceding boom. However, whilst not knowing much of Garton's record, another academic has been more successful in calling the real economic situation, and that is Nouriel Roubini. As for Garton, he sees a major shift occurring, and he is offering an analysis in which he confirms my views that the RMB will replace the $US as the reserve currency.
Besides that, if China continues to raise questions about the dominance of the US dollar and the need for an alternative monetary system, other countries may have no choice but to listen – and gradually act. An eclipse of the dollar would be mirrored by a rise in the use of the renminbi. That would guarantee Shangkong’s prominence.
It is noteworthy that the Telegraph is alone among UK newspapers in picking up Roubini's thoughts, reflecting the Telegraph's role as the most intelligent (UK) paper on the subject of the economy. The original article was published in the New York Times and can be found here. Roubini points to the history of previous reserve currency shifts, for example from the £GB to the $US, pointing out that reserve currencies are held by creditors, not borrowers and that excessive borrowing by a reserve issuer undermines reserve status. His argument is quite persuasive, and I therefore recommend reading the complete article.
However, in a couple of respects I believe that Roubini is completely wrong. For example, he says the following:
We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.This is exactly the kind of wrong headed thinking that has led to the current situation. The ability to borrow huge sums of money is not a good thing, but a risk associated with being a reserve currency. The ability to raise more debt than can be repaid is a problem - not a benefit. It allows a government to act beyond the usual constraints of debt markets, allows large current account deficits, and mutes what would otherwise be powerful market signals. In other words, without the reserve status the $US would have slid long ago, and the US would have needed to have reformed before reaching the current crisis situation.
Another problem I have with Roubini's analysis is the question of timing. He has the following to say:
At the moment, though, the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. China has already flexed its muscle by setting up currency swaps with several countries (including Argentina, Belarus and Indonesia) and by letting institutions in Hong Kong issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency.He goes on to suggest that it will take ten years for the shift to take place. This seems to contradict the rest of his argument, which highlights the underlying weakness in the $US and the underlying strength of the RMB. As he identifies at the start of the article, reserve currency status is linked to creditor status. In the case of the $US, there is a massive and expanding deficit, no prospect of a return to surplus, and a deliberate policy of massive currency issuance through quantitative easing policy (printing money). Why would it take ten years for the shift to take place?
Another point is that he is suggesting that China make its bond market 'more liquid'. I am not sure, in this context, what he means, but he may be implying that this might mean issuance of greater numbers of bonds. If China were to do so, this would simply replicate the problems that the US eventually suffered. Issuance of debt is not a requirement for reserve currencies, and it is the lack of debt that is one of the reasons for the inherent strength of the RMB. However, maybe I am misunderstanding his intended meaning. The point is that a reserve currency simply needs to have sufficient issuance to cover internal needs for a unit of exchange and sufficient to allow for the currency to be used for external trade.
The trick is to issue sufficient for these needs to prevent appreciation/depreciation of the currency. After all, a currency is a unit of exchange....and reserve status means that it is possible to issue greater quantity without implying that there is a full immediate redemption of the unit in goods or services (I discuss the underlying value of currency here, and the nature of reserve status here).
As it is, as I have pointed out in previous posts, China is slowly but surely maneuvering the RMB into a position where it does indeed become the reserve currency. In a recent post, several commentators have added to the evidence of this progressive process by linking to an article from a blogger here. A later commentator then linked to the possible source of the blogger's article (thanks for the link, Gina), which was an article in The China Post:
HONG KONG -- About 50 percent of Hong Kong's trade with China may be settled in yuan as exporters reduce their exposure to a weakening dollar, Industrial & Commercial Bank of China (Asia) Ltd. said.This is just a further addition to the many small moves (see the links to my earlier posts) that have been made by China to initiate the RMB as a currency for trade settlement. Whilst each move in isolation might not be meaningful, the overall pattern is clear. The only element lacking is any official acknowledgement of the process in China, which has instead been to focus attention on the weakness of the $US, and to create a red-herring of IMF SDR's as an alternative reserve. As I have pointed out previously, the Chinese government will rarely take an open position on such a subject, and instead use proxies and indirect methods to lay out their position. However, ignoring the official position and looking instead at actions, there is every reason to think that China is now on the way to an official policy of RMB reserve status.
The first settlements of international trade using China's currency will start with about 400 Chinese companies in five pilot cities, Stanley Wong, deputy general manager at the unit of China's biggest bank, said in an interview today in Hong Kong. The payments may expand to half of all trade when authorities extend the program nationwide as soon as 2010, he said.
“There has been a perception that the U.S. dollar will continue to weaken,” said Wong. “Definitely on an annual basis, the yuan will probably appreciate against the U.S. dollar around 3 percent to 5 percent. It makes sense for companies to avoid foreign-exchange risk.”
In many of my early posts, I pointed to a fundamental shift in the underlying shape of the world economy (summarised here), and have explained that this is the underlying reason for the current economic crisis. The more I have looked at the part that China has played in this change, the more apparent that it has become that China has moved to the centre stage of the world economy. Having said this, I have often issued caveats to my analysis, in particular emphasising the risks that are inherent in the Chinese policies. I still hold to those caveats, but I am increasingly of the view that the actions of China are both farsighted and likely to prove effective in shifting economic power into their hands.
In the meantime, US policies appear to be perfectly formulated to encourage and support the shift in power. Their profligacy, and outright rejection of reform, are catalysts for the process, and will make the shift occur more quickly, and with greater effect.
If the US continues on the current path, it is quite possible to imagine the arguments of future historians. They will view the Bush and Obama years as the critical years in the loss of US power, and the decline of the US economy. They will point to the debt accumulation, government profligacy, populist policy, the irresponsibility of the Federal Reserve, and the failure to confront the mercantilist policies of China - the argument will be over which was the nail in the coffin of US power. From my point of view, the argument is that it is impossible to view any of these factors in isolation, but rather to view them as part of a single process.
The single process that unifies all of these elements is self-delusion. It is the belief that power is an inherent right, that wealth is an inherent right, and that underlying economic realities might be wished away. In short, the leaders, the analysts, and the people of the US forgot that power and success are rooted in real wealth creation, not the ersatz wealth of borrowing and printing money.
As yet, there is no guarantee of the shift in power towards China. There are many risks, and China is operating in a dynamic system, in which outcomes will always be uncertain. Having said this, their overall strategy appears to be bearing fruit and, with the help of US policy, they are now firmly on track for success.
Quite simply, I believe that they are winning, and others are starting to share this view.
Another interesting point that Roubini makes is in his discussion, which is on a different subject to the main article is as follows:
But what could replace it [the $US]? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi.Regular readers will know that I have flirted with the idea of a gold standard in currencies, but eventually came to the idea of a currency of fixed issuance (the link is to a long article that approaches the subject is a fairly roundabout way). I am somewhat surprised to see an economist using emotive terms such as 'barbaric relic' in reference to a gold based currency. This is not an explanation of why gold is not a viable alternative, but an emotive argument. The reality is that, in the current situation, it is possible to see how easily governments and central banks can debase a fiat currency when there is no restraint on the issuance. Whilst no longer subscribing to a gold standard, I believe that some form of restraint on issuance of currency is better than the current situation of no restraint.
The very essence of Roubini's argument is that the unrestrained issuance of currency has created the current problems, and it is difficult to see how such issuance might be restrained without some kind of commodity backing. A 'barbaric' gold standard currency would have prevented this mess, as gold would have flowed out of the US with the massive deficits, and therefore the currency issuance would have been constrained.
If that is barbaric, then I am all in favour of barbaric.
I found a fascinating clip that illustrates how shockingly opaque the Federal Reserve actually is. This is, of itself, a subject of a post. The clip can be found here. You may be shocked.....
So much for the 'Green Shoots'. The US consumer has apparently been (as expected by anyone grounded in reality) pulling in their horns. Taylor, of the famous Taylor rule, is suggesting that US interest rates will need to rise in the near term, in an analysis that slams down much of the recent optimism and analysis of the situation. Meanwhile Freddie Mac is drawing on another $6 billion due to ongoing losses - but apparently the crisis is now over....??? and foreclosures continue at shocking levels...
More depressing, from the UK there is news of a lift in the numbers of first time house buyers. I feel sorry for these individuals, who are no doubt reading of recovery, and optimism, and are thinking to climb onto the housing ladder whilst there is still time....no doubt they will hear this story in the press, and from the mouths of the estate agents. They are, of course, buying long before the bottom has been reached. For example, the buy to let market looks dire, and signals more properties coming onto the market at discounted prices. As for the economy overall, the BoE has come in with a pretty gloomy picture in the latest inflation report, which can be found here....(the GDP projections might be seen as good material for black humour).
The idiocy of the US bailout schemes is highlighted in an article here, which also serves to confirm the 'clubiness' that I detailed in a recent article:
“The taxpayers ought to know that we are in effect receiving a subsidy. They put in 40pc of the money but get little of the equity upside,” said Mark Patterson, chairman of MatlinPatterson Advisers.
The comments are likely to infuriate Tim Geithner, the US Treasury Secretary, because MatlinPatterson took advantage of the TARP’s matching funds to buy Flagstar Bancorp in Michigan. His confession appears to validate concerns that the bail-out strategy is geared towards Wall Street.
Thanks, as ever for the comments. There was a little tension between two commentators, and I was glad to see the tension resolved in such a reasonable way. As ever, the standard of the comments and intelligence of the commentators is a pleasure to see.
Apologies for linking to so many old articles, but this appears the best way to highlight the overall picture of China. I hope that readers have the time to view these, as they do together paint (I believe) a compelling picture.