Economic commentators have often praised Chinese banks for the prudent lending policies that protected China from the excesses of the Western financial system.
That was then. Now is very different.
The recession that simultaneously hit Japan, Europe and the United States strongly reduced demand for Chinese exports, which account for a third of the national Gross Domestic Product. With unemployment rising and social unrest always close to the surface, the government needed to react quickly.
Simply raising consumption would not be enough. First, internal consumption in China, in terms of percentage of GNP, is less than half of the U.S. figure. Second, only a small fraction of the Chinese population can consume on the Western scale, and this is not enough to absorb the mountain of goods America and Europe no longer buy.
Only infrastructure investment, meaning housing, railways, airports, roads and the like, would permit spending on the scale required to compensate for the fall in exports.
China has in recent years made huge strides in infrastructure development, but it is still a command economy, meaning that major projects are funded and implemented according to a central plan. Running a massive spending package through the normal state planning process would have taken far too long.
So the banking system was chosen as the fast-track channel. Banks were told to lend, lend, lend, and lend some more. Convinced that the government would cover losses, the banks did just that, handing out close to a trillion dollars in new loans in the first six months of 2009.
That is over one fifth of the GNP within half a year. The money has gone to individuals, corporations, state-owned enterprises, real estate developers, and local and provincial governments.
Even with the greatest good will and talent, it would be hard to invest that much money in bona fide projects. Much of it has gone back into bank deposits, which pay interest rates higher than those due on loans. Another portion feeds into the stock market, which has risen over sixty percent since the lending spree began.
In other words, much of the money is either diverted or used in speculation. Even if it is actually invested in infrastructure, it is impossible to guarantee the long-term viability of the projects. And the longer the money spigots stay open, the less the value of such projects is likely to become, and the greater will be the share of total spending diverted to speculative activities.
With some differences due to local circumstances, the Chinese government is thus creating the same kind of speculative bubble as developed in the U.S. between 2002 and 2007, with the same consequences. The primary difference is that the Chinese bubble is inflating much faster than ours did.
The result, however, is likely to be the similar: a financial free-for-all for a year or so, followed by a wave of defaults, a stock market crash and an abrupt economic downturn, with the Chinese population left holding the bag.
The hope of the leadership may be that before such a crash occurs, Western economies will have recovered enough to start the Chinese export sector growing again. This would be a neat trick but is becoming less likely with each passing month. The Western consumer is tapped out and will not resume past free-spending ways for a long time, if ever.
The eventual bursting of the Chinese credit bubble will have a significant impact on the global economy. It will prolong the current recession, lower the price of energy and raw materials, and further shake up the world financial system. It shall also to quash any remaining notion that economic globalization was ever anything more than a very expensive mistake.
The psychological impact will be just as important. China is currently looked upon as the motor and hope of global recovery. If China succumbs to an acute case of the Western credit disease that it was supposedly immune to, current economic thinking will be left without any support.
Finally, the crisis in China will leave the United States without its preferred political and commercial partner of the last twenty years, and force a complete realignment of its trade and foreign policy.
Wednesday, July 1, 2009
Wednesday, June 10, 2009
China's New Threat to the Dollar
Current Chinese and American monetary policies are diametrically opposed.
China has based its growth and rise to economic prominence on an export-led economic model, with the United States as a primary destination for Chinese-made goods. The result of this policy is a two trillion dollar foreign exchange reserve, of which roughly 60% is denominated in dollars.
The US, on the other hand, has chosen a policy of monetary easing in to fight the current recession. It is running huge budget deficits, part of which is financed through money creation by the Federal Reserve. Such a vast increase in money supply can only lead to a devaluation of the dollar, which reduces the value of Chinese reserves.
The Chinese cannot allow thirty years’ worth of currency accumulation to evaporate as a result of inflationary US policy. They have sent US authorities repeated messages to that effect, including: top-level statements of concern; massive purchases of strategic metals; announcing their gold reserves are twice the size previously thought; reducing purchases of longer-term Treasury bonds.
The most recent Chinese move has been to start negotiations with Brazil to cut the dollar out of their mutual trade relations, which would rely on national currencies instead.
In response US Treasury Secretary Tim Geithner traveled to Beijing in late May to reassure the Chinese concerning US policies. Perfunctory statements of agreement were exchanged as he left China. But on the day after Mr. Geithner’s departure, China announced negotiations with Malaysia similar to those with Brazil: no more dollar-denominated trade there either.
In other words, the visit by Mr. Geithner solved nothing. However, it goes way beyond that. The announcement is not just another message to the United States. It can well be the start of a new monetary strategy.
The type of economic transaction under negotiation with Brazil and Malaysia is essentially a barter deal based on the relative values of the two national currencies involved. As China has a large economy involving many buyers and suppliers, such a type of transaction can be expanded to any number of its trading partners, thereby creating a fairly large dollar-free economic zone.
This would in the short term reduce the importance of the dollar as the dominant world currency. The ultimate effect would be much more far-reaching.
The global primacy of the dollar is to a great extent based on the assumption that there is no available substitute for it. The above strategy of dollar-free transactions, which is quite workable, undermines this assumption by showing that in many cases such a substitute is not needed. All that is required is agreement on the relative value of two national currencies.
Furthermore, if demonstrated successfully between, for example, China and Brazil, such a bilateral commercial strategy could be applied to transactions between countries other than China. Russia and Germany, for example, could in the same manner exchange energy products for engineering goods and services.
Finally, this approach to trade would gradually extinguish the dollar’s key role in pricing commodities, such as oil, sugar, copper or grains. These commodities would de facto come to be priced in terms of a basket of currencies, based on the actual volume of transactions in the various national units of account.
The dollar would then be then reduced to being the national currency of the United States, with significant consequences for this country and for the rest of the world. The US, no longer able to rely on the dollar’s global role, would like any other country be fully responsible for the value of its own currency.
The Chinese initiative is therefore no idle threat. Whether the Chinese government will implement this new strategy across the board or even on a large scale is unknown. Very possibly they have no definite plan at this point. But a whole realm of possibilities has been opened.
What is certain is that the US government must now face the fact that its policies, so far dictated strictly by domestic concerns, may in the very near future have a major and lasting impact on the status of its currency.
China has based its growth and rise to economic prominence on an export-led economic model, with the United States as a primary destination for Chinese-made goods. The result of this policy is a two trillion dollar foreign exchange reserve, of which roughly 60% is denominated in dollars.
The US, on the other hand, has chosen a policy of monetary easing in to fight the current recession. It is running huge budget deficits, part of which is financed through money creation by the Federal Reserve. Such a vast increase in money supply can only lead to a devaluation of the dollar, which reduces the value of Chinese reserves.
The Chinese cannot allow thirty years’ worth of currency accumulation to evaporate as a result of inflationary US policy. They have sent US authorities repeated messages to that effect, including: top-level statements of concern; massive purchases of strategic metals; announcing their gold reserves are twice the size previously thought; reducing purchases of longer-term Treasury bonds.
The most recent Chinese move has been to start negotiations with Brazil to cut the dollar out of their mutual trade relations, which would rely on national currencies instead.
In response US Treasury Secretary Tim Geithner traveled to Beijing in late May to reassure the Chinese concerning US policies. Perfunctory statements of agreement were exchanged as he left China. But on the day after Mr. Geithner’s departure, China announced negotiations with Malaysia similar to those with Brazil: no more dollar-denominated trade there either.
In other words, the visit by Mr. Geithner solved nothing. However, it goes way beyond that. The announcement is not just another message to the United States. It can well be the start of a new monetary strategy.
The type of economic transaction under negotiation with Brazil and Malaysia is essentially a barter deal based on the relative values of the two national currencies involved. As China has a large economy involving many buyers and suppliers, such a type of transaction can be expanded to any number of its trading partners, thereby creating a fairly large dollar-free economic zone.
This would in the short term reduce the importance of the dollar as the dominant world currency. The ultimate effect would be much more far-reaching.
The global primacy of the dollar is to a great extent based on the assumption that there is no available substitute for it. The above strategy of dollar-free transactions, which is quite workable, undermines this assumption by showing that in many cases such a substitute is not needed. All that is required is agreement on the relative value of two national currencies.
Furthermore, if demonstrated successfully between, for example, China and Brazil, such a bilateral commercial strategy could be applied to transactions between countries other than China. Russia and Germany, for example, could in the same manner exchange energy products for engineering goods and services.
Finally, this approach to trade would gradually extinguish the dollar’s key role in pricing commodities, such as oil, sugar, copper or grains. These commodities would de facto come to be priced in terms of a basket of currencies, based on the actual volume of transactions in the various national units of account.
The dollar would then be then reduced to being the national currency of the United States, with significant consequences for this country and for the rest of the world. The US, no longer able to rely on the dollar’s global role, would like any other country be fully responsible for the value of its own currency.
The Chinese initiative is therefore no idle threat. Whether the Chinese government will implement this new strategy across the board or even on a large scale is unknown. Very possibly they have no definite plan at this point. But a whole realm of possibilities has been opened.
What is certain is that the US government must now face the fact that its policies, so far dictated strictly by domestic concerns, may in the very near future have a major and lasting impact on the status of its currency.
Wednesday, June 3, 2009
Global Warming Update
In the general public discourse the climate change debate has been, so far, confined almost entirely to the greenhouse gas issue. Our economy’s carbon footprint utterly dominates all climate change discussions.
In actual fact there are several major influences acting on the global climate in terms of raising or lowering atmospheric temperatures.
The warming induced by greenhouse gases, such as carbon dioxide and methane, is the first such influence. However, while the physics of the greenhouse effect are clear, the chain of causality between greenhouse gas accumulation in the atmosphere and specific weather patterns is not fully understood. At this time the actual consequences of such accumulation cannot be accurately predicted in terms of timing and impact.
The second influence comes from periodic variations in the earth’s orbit around the sun and in the inclination of its axis. These cyclical variations have been relatively well correlated with past ice ages and warmer inter-glacial periods. According to some recent published research in this area our planet would currently be sliding into another cold period or ice age, although the timing is hard to pin down.
The third influence, which has come into prominence only recently, is solar activity as manifested through the sunspot cycle. For the earth, a high sunspot count means warming, a low count cooling. Although the basic cycle has an average periodicity of eleven years, there are also long term variations which are not well understood. Sunspot activity has just reached a low which may or may not be significant. But if this low persists, significant cooling can be expected.
One can conclude that the overall picture is becoming increasingly ambiguous. Greenhouse gas accumulation due to the use of fossil fuels is no longer the only story in town, nor is warming the most likely future outcome.
The purpose here is not to claim that greenhouse gas accumulation is not significant. It is to warn that other influences are in play which can be equally important, and that our scientific understanding must be increased before major economic measures, such as a tax on carbon emissions, are implemented.
One such measure, a so-called “cap and trade” scheme, is currently under discussion in the US Congress. Such a scheme has considerable drawbacks.
First, it amounts to a highly regressive tax on energy, which will disproportionally affect the lower income fractions of the population. Second, it introduces huge market distortions which vastly complicate efforts to deal with the gradually increasing price and reduced availability of petroleum.
To be successful, such efforts require first and foremost a realistic and workable long-term energy strategy, the elaboration of which must precede any large-scale government intervention in the energy area. The US government at this time does not have such a strategy, which, as far as its impact on climate is concerned, must rest on a much better scientific understanding of the various influences on climate listed above.
Funding to increase and test this understanding will have a far greater impact than any of the currently proposed schemes to reduce carbon emissions. Until such understanding is on more solid footing, there is no valid justification for major initiatives in economic policy on climate change grounds.
In actual fact there are several major influences acting on the global climate in terms of raising or lowering atmospheric temperatures.
The warming induced by greenhouse gases, such as carbon dioxide and methane, is the first such influence. However, while the physics of the greenhouse effect are clear, the chain of causality between greenhouse gas accumulation in the atmosphere and specific weather patterns is not fully understood. At this time the actual consequences of such accumulation cannot be accurately predicted in terms of timing and impact.
The second influence comes from periodic variations in the earth’s orbit around the sun and in the inclination of its axis. These cyclical variations have been relatively well correlated with past ice ages and warmer inter-glacial periods. According to some recent published research in this area our planet would currently be sliding into another cold period or ice age, although the timing is hard to pin down.
The third influence, which has come into prominence only recently, is solar activity as manifested through the sunspot cycle. For the earth, a high sunspot count means warming, a low count cooling. Although the basic cycle has an average periodicity of eleven years, there are also long term variations which are not well understood. Sunspot activity has just reached a low which may or may not be significant. But if this low persists, significant cooling can be expected.
One can conclude that the overall picture is becoming increasingly ambiguous. Greenhouse gas accumulation due to the use of fossil fuels is no longer the only story in town, nor is warming the most likely future outcome.
The purpose here is not to claim that greenhouse gas accumulation is not significant. It is to warn that other influences are in play which can be equally important, and that our scientific understanding must be increased before major economic measures, such as a tax on carbon emissions, are implemented.
One such measure, a so-called “cap and trade” scheme, is currently under discussion in the US Congress. Such a scheme has considerable drawbacks.
First, it amounts to a highly regressive tax on energy, which will disproportionally affect the lower income fractions of the population. Second, it introduces huge market distortions which vastly complicate efforts to deal with the gradually increasing price and reduced availability of petroleum.
To be successful, such efforts require first and foremost a realistic and workable long-term energy strategy, the elaboration of which must precede any large-scale government intervention in the energy area. The US government at this time does not have such a strategy, which, as far as its impact on climate is concerned, must rest on a much better scientific understanding of the various influences on climate listed above.
Funding to increase and test this understanding will have a far greater impact than any of the currently proposed schemes to reduce carbon emissions. Until such understanding is on more solid footing, there is no valid justification for major initiatives in economic policy on climate change grounds.
Are the Wars on Terror Winnable
Any serious analysis of the status of the the so-called war on terror brings up an apparent contradiction.
On the one hand, any opinion survey in the affected areas clearly shows that terrorist entities or radical groups allied with them, such as Al Qaeda and the Taliban, are deeply unpopular. On the other is the fact that despite a major outlay of resources and the superiority of US forces, the various conflicts drag on and the final outcome is far from certain.
US troops are not to blame. Aside from a few isolated cases they have performed with dignity, honor and professionalism. They also have undeniable superiority in firepower and organization.
Also to be set aside is the argument that the enemy benefits from the support of rogue states such as Iran. Such support, when it exists, is very limited in comparison to the huge US effort. In addition Iran or other states might provide some weapons and training, but not the rank-and-file fighters willing to face US firepower.
The vast majority of these fighters are not members of terrorist organizations, which by necessity are always small and secretive. Nevertheless they fight alongside them, thereby providing true terrorists support, cover, and the opportunity to recruit members and raise funds.
True terrorist numbers are too small to account for anything except focused, showcase operations. If they could be isolated from the much larger numbers of combatants who do not share their goals or tactics, their elimination could be achieved with a relatively low expenditure of resources. This separation between true terrorists and the much larger numbers of those who could simply be called insurgents is therefore the key to winning the various conflicts we are currently involved in.
What are these insurgents then fighting for? There are two answers to this question, and both involve basic US policies.
The first fundamental issue is that no population easily accepts foreign occupation. The standard US policy within the war on terror has been the invasion and occupation of suspect territory by large conventional forces. This is then followed by some form of what we call nation-building, or the restructuring of the subject society according to a model we define. Such an approach will inevitably provoke resistance, supported by appeals to defend traditional culture and values.
The second issue is the US preference for unitary government, ignoring the fact that many of the countries subject to the war on terror are not nations, but fairly artificial states comprising a variety of ethnic, religious and cultural entities. Such entities have legitimate grievances and needs which generally cannot be met within a centralized government structure, however democratic it is in theory.
Neglect of legitimate aspirations for cultural and political autonomy breeds discontent, which is compounded by the humiliation and collateral damage brought by occupation. This creates a fertile ground for insurgencies of various kinds, within which genuine terrorists can pose a sympathizers and allies.
Such insurgencies can be kept down by brute force, but they will continue to smolder underground, ready to explode as soon as force is removed. Their resolution requires a basic reassessment of our policies along the following lines:
We must recognize that it is counter-productive for the US to attempt to shape foreign states and cultures according to our own concepts, particularly is this is accomplished through military force.
The United States government must recognize and support the principle of self-determination for ethnic, religious and cultural communities.
The recommended policies would not only be in accord with the values on which our own nation is built, but it will provide with far more leverage than the strategies we currently use.
On the one hand, any opinion survey in the affected areas clearly shows that terrorist entities or radical groups allied with them, such as Al Qaeda and the Taliban, are deeply unpopular. On the other is the fact that despite a major outlay of resources and the superiority of US forces, the various conflicts drag on and the final outcome is far from certain.
US troops are not to blame. Aside from a few isolated cases they have performed with dignity, honor and professionalism. They also have undeniable superiority in firepower and organization.
Also to be set aside is the argument that the enemy benefits from the support of rogue states such as Iran. Such support, when it exists, is very limited in comparison to the huge US effort. In addition Iran or other states might provide some weapons and training, but not the rank-and-file fighters willing to face US firepower.
The vast majority of these fighters are not members of terrorist organizations, which by necessity are always small and secretive. Nevertheless they fight alongside them, thereby providing true terrorists support, cover, and the opportunity to recruit members and raise funds.
True terrorist numbers are too small to account for anything except focused, showcase operations. If they could be isolated from the much larger numbers of combatants who do not share their goals or tactics, their elimination could be achieved with a relatively low expenditure of resources. This separation between true terrorists and the much larger numbers of those who could simply be called insurgents is therefore the key to winning the various conflicts we are currently involved in.
What are these insurgents then fighting for? There are two answers to this question, and both involve basic US policies.
The first fundamental issue is that no population easily accepts foreign occupation. The standard US policy within the war on terror has been the invasion and occupation of suspect territory by large conventional forces. This is then followed by some form of what we call nation-building, or the restructuring of the subject society according to a model we define. Such an approach will inevitably provoke resistance, supported by appeals to defend traditional culture and values.
The second issue is the US preference for unitary government, ignoring the fact that many of the countries subject to the war on terror are not nations, but fairly artificial states comprising a variety of ethnic, religious and cultural entities. Such entities have legitimate grievances and needs which generally cannot be met within a centralized government structure, however democratic it is in theory.
Neglect of legitimate aspirations for cultural and political autonomy breeds discontent, which is compounded by the humiliation and collateral damage brought by occupation. This creates a fertile ground for insurgencies of various kinds, within which genuine terrorists can pose a sympathizers and allies.
Such insurgencies can be kept down by brute force, but they will continue to smolder underground, ready to explode as soon as force is removed. Their resolution requires a basic reassessment of our policies along the following lines:
We must recognize that it is counter-productive for the US to attempt to shape foreign states and cultures according to our own concepts, particularly is this is accomplished through military force.
The United States government must recognize and support the principle of self-determination for ethnic, religious and cultural communities.
The recommended policies would not only be in accord with the values on which our own nation is built, but it will provide with far more leverage than the strategies we currently use.
The Green Shoots Illusion
There appear to be two camps forming among financial and economic commentators. The more numerous faction, which also includes most stock market players, the Federal Reserve and the Administration, flies the “green shoots” flag. Its prevailing opinion is that thanks to timely government action “another Great Depression” has been avoided, the national and global economies are now reaching bottom and renewed growth is not far away. Hopes and analyses along these lines have fueled the world stock market rally which began in early March.
The other and smaller group is more cautious and less optimistic. To them the “green shoots” are wiggles in the charts and the basic economic numbers do not support the above conclusions. In fact, the data still points downward and the bottom is not in sight, much less any kind of recovery.
The bullish party rests its analysis on the effectiveness of government intervention, which would have prevented total disaster and is now “turning the economy around”. To test this assumption it is worthwhile to reflect on the nature and purpose of government intervention in the economy.
For the sake of clarity one can fit such interventions in either of two categories. One is a process of nationalization of the whole or of certain parts of the economy. Such action is based on the assumption that the government will do a better job of running the economy, or selected parts of it, than the private sector . This is the fundamental assumption of socialism.
The other category of state intervention is regulation, through which the government acts to correct private sector excesses, but without assuming either full control or ownership.
What we have seen in the United States since 2007 fits neither category, but falls right between them.
First, no nationalization has been implemented. Now, whatever can be said about the benefits and shortcomings of socialism, it is a coherent economic philosophy that has been extensively tried, and in certain cases has achieved the goals set for it. It is therefore a valid model for certain purposes, but it is not being applied here.
Modification of economic parameters and activities through regulation has also been largely absent.
In fact government intervention in the last two years, although massive, has been primarily aimed at the maintenance and restoration of the status quo ante: getting the “financial system to function again”, “saving the banks too big to fail”, “restoring the auto industry”, returning to growth, and so on. Vast sums of money have been expended or pledged, but no activities have been forbidden or outlawed, no management purges have taken place, and no new economic strategy formulated. What has happened is not so much an overhaul of the economy, but a sudden and vast expansion of government into the financial and economic spheres, proceeding mostly on an ad hoc basis.
Because such intervention, while not being a shift to true socialism, nevertheless has a considerable distorting effect on market mechanisms, it is right to ask whether it will ever actually “fix” the economy. It is quite possible that it has, in fact, achieved the opposite effect. On the one hand the market has been shackled and is no longer free to work its way and purge the economy of accumulated dross.
On the other hand the government is far from having the level of control needed to implement a coherent economic strategy. The two influences basically cancel each other out. Aside from being extremely costly, the kind of state intervention we have seen to date is most likely to lead to paralysis, with and an economy that is not so much “fixed” as frozen in place and unable to move.
To return to the botanical analogy, there are “green shoots” to be observed in every situation. The question to be asked is whether they are productive plants, weeds or parasitic growth. In our present economic situation the latter two appear to dominate.
The other and smaller group is more cautious and less optimistic. To them the “green shoots” are wiggles in the charts and the basic economic numbers do not support the above conclusions. In fact, the data still points downward and the bottom is not in sight, much less any kind of recovery.
The bullish party rests its analysis on the effectiveness of government intervention, which would have prevented total disaster and is now “turning the economy around”. To test this assumption it is worthwhile to reflect on the nature and purpose of government intervention in the economy.
For the sake of clarity one can fit such interventions in either of two categories. One is a process of nationalization of the whole or of certain parts of the economy. Such action is based on the assumption that the government will do a better job of running the economy, or selected parts of it, than the private sector . This is the fundamental assumption of socialism.
The other category of state intervention is regulation, through which the government acts to correct private sector excesses, but without assuming either full control or ownership.
What we have seen in the United States since 2007 fits neither category, but falls right between them.
First, no nationalization has been implemented. Now, whatever can be said about the benefits and shortcomings of socialism, it is a coherent economic philosophy that has been extensively tried, and in certain cases has achieved the goals set for it. It is therefore a valid model for certain purposes, but it is not being applied here.
Modification of economic parameters and activities through regulation has also been largely absent.
In fact government intervention in the last two years, although massive, has been primarily aimed at the maintenance and restoration of the status quo ante: getting the “financial system to function again”, “saving the banks too big to fail”, “restoring the auto industry”, returning to growth, and so on. Vast sums of money have been expended or pledged, but no activities have been forbidden or outlawed, no management purges have taken place, and no new economic strategy formulated. What has happened is not so much an overhaul of the economy, but a sudden and vast expansion of government into the financial and economic spheres, proceeding mostly on an ad hoc basis.
Because such intervention, while not being a shift to true socialism, nevertheless has a considerable distorting effect on market mechanisms, it is right to ask whether it will ever actually “fix” the economy. It is quite possible that it has, in fact, achieved the opposite effect. On the one hand the market has been shackled and is no longer free to work its way and purge the economy of accumulated dross.
On the other hand the government is far from having the level of control needed to implement a coherent economic strategy. The two influences basically cancel each other out. Aside from being extremely costly, the kind of state intervention we have seen to date is most likely to lead to paralysis, with and an economy that is not so much “fixed” as frozen in place and unable to move.
To return to the botanical analogy, there are “green shoots” to be observed in every situation. The question to be asked is whether they are productive plants, weeds or parasitic growth. In our present economic situation the latter two appear to dominate.
Thursday, May 7, 2009
The Coming Confrontation Over the Dollar
An interesting article was published in the Financial Times on May 5th. Titled “If China Loses Faith the Dollar will Collapse”, written by Mr. Andy Xie, an economist in Shanghai, the article clearly points to the next phase of the global financial crisis.
In many ways the US and China are the main actors in the developing financial crunch. The US, through its trade and budget deficits, has pumped huge amounts of dollars into the global system. China, on the other hand, has soaked up these dollars through its large trade surpluses, accumulating over a trillion and a half in foreign currency reserves, most of which are dollar-denominated.
In the recent past this arrangement has served both countries well, allowing them to pursue their chosen economic and fiscal policies. But it has also created the huge financial imbalance which is at the root of the current crisis. And because of the crisis the collaboration between the two powers is quickly morphing into confrontation.
On the Chinese side, the accumulated dollar reserves are critical to the country’s further development. As the Chinese economy grows it needs increasing amounts of foreign currency to purchase the raw materials, such as oil and industrial metals, it no longer produces in sufficient quantities. It also needs the money to acquire the technologies, equipment and armaments it is not yet capable of developing on its own. To pursue its industrial growth and its strategic expansion China therefore needs its monetary reserves to keep their current value. In practice, this means a strong and stable dollar.
The US, on the other hand, is in the grip of a financial meltdown and a severe recession. The Federal Reserve has chosen to cure the financial problems by vastly increasing the amount of liquidity in the financial system, printing or creating money by fiat if necessary. The Obama administration is fighting the recession by the same methods: huge budget deficits and stimulus programs to “jump start” the economy and revive private consumption. To put it simply, the US is attempting to inflate itself out of the crisis. As this is rapidly increasing the amount of money in circulation, the dollar will inevitably lose value.
The economic and fiscal policies of China and the US are thus incompatible: if the US policy is maintained, Chinese dollar reserves will decline in value with respect to the goods China needs; but the only way for the dollar to remain stable is for the US government to abandon or sharply curtail its anti-recession policies. At this point neither side is giving in. In fact they do not appear to even be talking about this major issue.
The Chinese government has, for the last six months, attempted to draw American attention to the problem, through official statements as well as large purchases of gold and strategic materials. Mr. Xie’s article has no overt tie to Chinese government policy, but its publication in the world’s premier financial newspaper gives food for thought. As written, it is a clear warning to the United States. It is doubtful the Chinese government would let such a statement go by unless they at least tacitly approved of it.
It is unlikely that the US government will pay attention, being preoccupied with the domestic situation and believing the Chinese do not really have a choice but to continue buying dollar-denominated US government debt. But the Chinese have already made their position clear: they will not tolerate a devaluation of the US currency and of the dollar reserves they already hold. They are thus likely to ratchet up both rhetoric and action, with the intensity of the dispute quickly escalating.
The danger here is not an overt confrontation or an “economic war”. More likely, in the absence of mutual understanding and compromise, one of the parties will try to make its point through a move – the consequences of which have not been foreseen. Such a move could roil the markets sufficiently to initiate a run on the dollar, potentially crashing the entire world financial system.
The world financial situation is still extremely unstable. It could take only a minor miscalculation to start another major panic, with consequences far more severe than anything that has happened so far.
In many ways the US and China are the main actors in the developing financial crunch. The US, through its trade and budget deficits, has pumped huge amounts of dollars into the global system. China, on the other hand, has soaked up these dollars through its large trade surpluses, accumulating over a trillion and a half in foreign currency reserves, most of which are dollar-denominated.
In the recent past this arrangement has served both countries well, allowing them to pursue their chosen economic and fiscal policies. But it has also created the huge financial imbalance which is at the root of the current crisis. And because of the crisis the collaboration between the two powers is quickly morphing into confrontation.
On the Chinese side, the accumulated dollar reserves are critical to the country’s further development. As the Chinese economy grows it needs increasing amounts of foreign currency to purchase the raw materials, such as oil and industrial metals, it no longer produces in sufficient quantities. It also needs the money to acquire the technologies, equipment and armaments it is not yet capable of developing on its own. To pursue its industrial growth and its strategic expansion China therefore needs its monetary reserves to keep their current value. In practice, this means a strong and stable dollar.
The US, on the other hand, is in the grip of a financial meltdown and a severe recession. The Federal Reserve has chosen to cure the financial problems by vastly increasing the amount of liquidity in the financial system, printing or creating money by fiat if necessary. The Obama administration is fighting the recession by the same methods: huge budget deficits and stimulus programs to “jump start” the economy and revive private consumption. To put it simply, the US is attempting to inflate itself out of the crisis. As this is rapidly increasing the amount of money in circulation, the dollar will inevitably lose value.
The economic and fiscal policies of China and the US are thus incompatible: if the US policy is maintained, Chinese dollar reserves will decline in value with respect to the goods China needs; but the only way for the dollar to remain stable is for the US government to abandon or sharply curtail its anti-recession policies. At this point neither side is giving in. In fact they do not appear to even be talking about this major issue.
The Chinese government has, for the last six months, attempted to draw American attention to the problem, through official statements as well as large purchases of gold and strategic materials. Mr. Xie’s article has no overt tie to Chinese government policy, but its publication in the world’s premier financial newspaper gives food for thought. As written, it is a clear warning to the United States. It is doubtful the Chinese government would let such a statement go by unless they at least tacitly approved of it.
It is unlikely that the US government will pay attention, being preoccupied with the domestic situation and believing the Chinese do not really have a choice but to continue buying dollar-denominated US government debt. But the Chinese have already made their position clear: they will not tolerate a devaluation of the US currency and of the dollar reserves they already hold. They are thus likely to ratchet up both rhetoric and action, with the intensity of the dispute quickly escalating.
The danger here is not an overt confrontation or an “economic war”. More likely, in the absence of mutual understanding and compromise, one of the parties will try to make its point through a move – the consequences of which have not been foreseen. Such a move could roil the markets sufficiently to initiate a run on the dollar, potentially crashing the entire world financial system.
The world financial situation is still extremely unstable. It could take only a minor miscalculation to start another major panic, with consequences far more severe than anything that has happened so far.
Monday, December 15, 2008
The Issue the Bail-outs do not Address
The financial crisis or “credit crunch” has triggered a series of rescue operations on an unprecedented scale. The Federal Reserve and the Treasury have spent and lent trillions of dollars, and committed trillions more. The financial situation has barely improved, which raises the question: Are these efforts aimed at the wrong target?
It is assumed, and widely reported, that this is a “liquidity crisis”. The banks are not lending to each other and to other entities because they are uncertain that the loans will be repaid. This is so because no one knows the state of the potential borrowers’ financial worth. And indeed, a number of prominent financial institutions have gone under in record time. Therefore the government is acting as a bank, providing capital, loans and rescue packages to just about everyone who asks, or even before they ask.
Such measures may be inevitable in the short term to avoid an immediate collapse, but the question remains: Why are balance sheets in such terrible shape after years of apparent prosperity and record profits? What has happened to create such rot?
The answer to the first question is simple: Balance sheets have accumulated a mountain of dubious, worthless and otherwise “toxic” assets, which cannot be sold because no one will buy them.
Why then were such assets created in the first place? The answer holds in one word: globalization.
Over the past twenty years, nearly all barriers to the free and global circulation of money, such as capital and currency exchange controls, have gradually been removed from the western financial system, creating a global financial market far larger than any national market had been before. This market was then tapped by a number of countries to fund large and growing fiscal and trade deficits. The US was particularly tempted to do this as the dollar was the world “reserve currency” and much of global financing transactions were done in dollars.
US trade and government deficits pumped up the amount of loose, unanchored money floating around the globe, looking for the highest possible returns. Since supply always tends to meet demand, an increasingly varied palette of “financial instruments” was created to absorb this growing monetary mass. The demand for ever higher yields led to these “assets” acquiring an increasingly speculative character, incorporating growing amounts of poorly defined risk. Thus was the stage set for a series of investment bubbles, with the growth in bubble size going in parallel with the amount of loose money looking for ever higher yields. The mortgage and commodity bubbles were only the latest to inflate and to pop. More are sure to follow.
The amount of money sloshing around the system is now so large that its movements overwhelm national safety and control systems. Calls for the creation of some kind of supranational monetary authority are possibly laudable but useless. No government will tolerate the surrender of sovereignty implicit on the creation of such a body.
In short: too much floating money creates inflated demand for “assets”, which are then created in a vacuum without corresponding collateral. At some point the value of such assets is questioned, their lack of worth is recognized, and the bubble pops. National institutions try to pick up the pieces while the stateless capital goes looking for another bubble opportunity.
Increasing liquidity might help locally and in the short term, but in the end it exacerbates the problem as it only adds to the loose monetary mass. There are only two ways to escape from this global cycle of ever increasing monetary oscillations.
One is to restore previously removed barriers and buffers: controls on capital movements and currency exchange rates, as well as customs duties. This was done with great success by Malaysia during the Asian crisis of 1997.
The other is to “mop up” the excess global liquidity by reducing fiscal and trade deficits, and creating opportunities for real, as opposed to purely financial, investment.
The second approach deserves more detailed analysis, and we will address this in a coming article.
It is assumed, and widely reported, that this is a “liquidity crisis”. The banks are not lending to each other and to other entities because they are uncertain that the loans will be repaid. This is so because no one knows the state of the potential borrowers’ financial worth. And indeed, a number of prominent financial institutions have gone under in record time. Therefore the government is acting as a bank, providing capital, loans and rescue packages to just about everyone who asks, or even before they ask.
Such measures may be inevitable in the short term to avoid an immediate collapse, but the question remains: Why are balance sheets in such terrible shape after years of apparent prosperity and record profits? What has happened to create such rot?
The answer to the first question is simple: Balance sheets have accumulated a mountain of dubious, worthless and otherwise “toxic” assets, which cannot be sold because no one will buy them.
Why then were such assets created in the first place? The answer holds in one word: globalization.
Over the past twenty years, nearly all barriers to the free and global circulation of money, such as capital and currency exchange controls, have gradually been removed from the western financial system, creating a global financial market far larger than any national market had been before. This market was then tapped by a number of countries to fund large and growing fiscal and trade deficits. The US was particularly tempted to do this as the dollar was the world “reserve currency” and much of global financing transactions were done in dollars.
US trade and government deficits pumped up the amount of loose, unanchored money floating around the globe, looking for the highest possible returns. Since supply always tends to meet demand, an increasingly varied palette of “financial instruments” was created to absorb this growing monetary mass. The demand for ever higher yields led to these “assets” acquiring an increasingly speculative character, incorporating growing amounts of poorly defined risk. Thus was the stage set for a series of investment bubbles, with the growth in bubble size going in parallel with the amount of loose money looking for ever higher yields. The mortgage and commodity bubbles were only the latest to inflate and to pop. More are sure to follow.
The amount of money sloshing around the system is now so large that its movements overwhelm national safety and control systems. Calls for the creation of some kind of supranational monetary authority are possibly laudable but useless. No government will tolerate the surrender of sovereignty implicit on the creation of such a body.
In short: too much floating money creates inflated demand for “assets”, which are then created in a vacuum without corresponding collateral. At some point the value of such assets is questioned, their lack of worth is recognized, and the bubble pops. National institutions try to pick up the pieces while the stateless capital goes looking for another bubble opportunity.
Increasing liquidity might help locally and in the short term, but in the end it exacerbates the problem as it only adds to the loose monetary mass. There are only two ways to escape from this global cycle of ever increasing monetary oscillations.
One is to restore previously removed barriers and buffers: controls on capital movements and currency exchange rates, as well as customs duties. This was done with great success by Malaysia during the Asian crisis of 1997.
The other is to “mop up” the excess global liquidity by reducing fiscal and trade deficits, and creating opportunities for real, as opposed to purely financial, investment.
The second approach deserves more detailed analysis, and we will address this in a coming article.
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