Tuesday, October 27, 2009

Global Imbalances...Part Two|Krugman no Longer on Dweeb Status

In the first post of The Sabrient Blog » Macro View of the Markets I concluded with the line: But in the meantime, do not expect the global imbalances to be corrected. This time I continue on with some of that same spirit by bringing up an article by Paul Krugman entitled: The Chinese Disconnect. Although it is widely common knowledge now about global imbalances, Krugman still has a platform to address these pedestrian issues which draws considerable attention.
Senior monetary officials usually talk in code. So when Ben Bernanke, the Federal Reserve chairman, spoke recently about Asia, international imbalances and the financial crisis, he didn’t specifically criticize China’s outrageous currency policy.

But he didn’t have to: everyone got the subtext. China’s bad behavior is posing a growing threat to the rest of the world economy. The only question now is what the world — and, in particular, the United States — will do about it.
Yes indeed about not needing to say who the gorilla in the room is as the IMF has been for years talking about global imbalances and all along tip toeing around China. But is it really that surprising that China followed the examples of the Asian Newly Industrialized Countries {i.e. Four Asian Tigers of Hong Kong, Singapore, South Korea and Taiwan as well as Japan earilier} as well as the sound advice from development economists in pursuing an export led path to development? Krugman does acknowledge that none of China's policies were anything out of the ordinary and was logical for a developing country, but it has been noted that only a certain group can get on that development escalator at one time. It is possible that only a few NICs can in fact get on the escalator but not everyone at one time as Paul Collier mentions in his books.

The trick is to know when to change course and when the structure of an economy needs to adapt to the evolving world economy. The structural elements that allowed Japan to rise to second highest GDP are the same structural elements that led to the lost decade(s). Will China be able to adapt?
And that’s a particularly bad thing to do at a time when the world economy remains deeply depressed due to inadequate overall demand. By pursuing a weak-currency policy, China is siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere. The biggest victims, by the way, are probably workers in other poor countries. In normal times, I’d be among the first to reject claims that China is stealing other peoples’ jobs, but right now it’s the simple truth.
I too am skeptical about "stealing other peoples' jobs" but in the least it does make it hard for other countries to be able to get on the development escalator. And even for high income countries there is a need to adjust their economies in timely fashion instead of a complete schizophrenic economy.
The point is that with the world economy still in a precarious state, beggar-thy-neighbor policies by major players can’t be tolerated. Something must be done about China’s currency.
Yes a precarious place and yes China is a major player but "something must be done" might create more harm than good. Well one aspect that does not seem palatable is to allow the Chinese to buy US assets as the Japanese did in the 70s and 80s. It did not hurt the USA and in fact probably was a net gain for the USA. Another fine article about the global imbalances is from the CFR at: Global Imbalances, National Rebalancing, and the Political Economy of Recovery. It provides some background on a couple of previous global imbalances including the US-German situation in the 1920s. In addition to the quote below, I would recommend reading the whole piece especially the quote of FDR.
The German-American financial relationship rested on weak political foundations, as neither country was really prepared for the implications of the capital flows. The United States was not willing to provide an open market for German goods that would facilitate debt service, or any government measures to deal with eventual financial distress, and the Germans were unwilling or unable to make the sacrifices necessary to provide prompt debt service.
The US now has gone full circle and while we are not in the dire straights of the Germans we are faced with similar situations. Instead of increasing our savings rates we are still priming the pump of Fiscal Stimulus and increasing debt levels as much as we can.

Normally I am a harsh critic of Krugman even if he does have a Nobel Prize but because of his podium he does get scrutinized. The Economist.com blog starts off with questioning the USA Pushing China. Direct threats or retaliation is not likely to get much traction as they are already aware that other developing countries and the EU are not happy with the Chinese actions and the IMF has been hinting for a long time about the global imbalances. The Economist continues with another post that includes some thoughts from Scott Sumner at: An expansionary peg?
Mr Krugman implicitly argues that a recovery which allows imbalances to persist is no recovery at all. Mr Sumner obviously thinks that exchange rate levels are irrelevant to imbalances. And I suppose I'm struggling to square the two views.
Without being too technical, Sumner basically points out the savings rates differences, which he uses to conclude that exchange rates do not matter. But to get to the exact portion let me quote it here:
In 1933 FDR was not trying to depreciate the dollar against other currencies, he was trying to depreciate it against goods and services. Krugman and I agree that we should be trying to do the same today. But if the Chinese were to appreciate their currency they would be imposing deflationary monetary policy on their economy...

It is a mistake to think about exchange rate policy as trade policy, it is fundamentally a form of monetary policy. China’s current account surplus is driven by its high saving rate, and changing the nominal exchange rate won’t have any significant effect as long as the savings rate remains high...
To myself that implies that incentives do not matter. That exchange rates have no effect on the economy. Then how did the low savings rates in the US come about? The mechanism is through the relative costs of tradable vs. non-tradable goods. As the Chinese currency appreciates then tradables become less expensive from abroad as well as the raw materials going into manufacturing.

Another way to look at this situation is through the absorption approach to the balance of payments {Laursen-Metzler effect}. Looking at it in the context of revaluations this would tell us that the income effect would increase Chinese consumption as they in effect have more disposable income {lowered prices of foreign products}, and the substitution effect would be to substitute domestic consumption that prices rose relatively for more external goods and services that became relatively less expensive.

Even if as Sumner states that "changing the nominal exchange rate won’t have any significant effect as long as the savings rate remains high" is correct, that considers that all actions by the central bank is in isolation. The Chinese may be looking to increase absorption {i.e. reduce savings rates} as well as reduce demands on export led development which will have effects on the current account balances.

Krugman comes back with a response and in his usual tone {"certain zombie fallacies — ideas that you kill repeatedly, but refuse to die —"} at: Adjustment and the dollar. While I agree with Krugman on most of his major points, the only question, as others have raised, is what can the USA insist on with-in reasonable expectations. I know of no one that wants a trade war now.


Links:
The Chinese Disconnect By PAUL KRUGMAN
An expansionary peg?
Adjustment and the dollar
Please China, keep “beggaring your neighbors.”
Pushing China Posted by: Economist.com | WASHINGTON

South-South Trade Tensions

FRBSF Economic Letter: Recent Developments in Mortgage Finance (2009-33, 10/26/2009)

***Two Views: Blame It on Beijing Redux, or Joint Determination
A New Meme: Blame It on Beijing (and Seoul, and Riyadh...)
Dollar Demise and Double Dip: Latest Forecasts
Guest Contribution: East Asian Production Networks, Global Imbalances, and Exchange Rate Coordination
Evaluating the new tools of monetary policy

Reports of the dollar's death are exaggerated By BARRY EICHENGREEN

Global Imbalances, National Rebalancing, and the Political Economy of Recovery
HT to EconBrowser:The Political Economy of Recovery and Rebalancing

Don't Let U.S. Capitalism Go the Italian Route
http://faculty.chicagobooth.edu/luigi.zingales/research/papers/capitalism_after_the_crisis.pdf

The growing case for a jobless recovery

Sensible
These are but two examples of Bartlett's revolutionary opinions that tax cuts don't pay for themselves and that taxation is not cyanide for job growth.


The Capital Spectator: DIVING INTO THE NUMBERS
THE CHALLENGE AHEAD
At the same time, it may be dawning on the crowd that the recovery, while looking intact for the moment, is set to be increasingly boring. The excitement of the past six months or so is on track for the dull business of looking forward, finding challenges and formulating responses. That's quite different from weighing the data du jour, looking backward and cheering that we've sidestepped a larger disaster.

The future, to put it bluntly, looks rather tedious from our perch.


China discloses currency basket composition
Composition of currency basket revealed
Zhou did not give details of the weightings of individual currencies in the basket.


China discloses currency basket composition

Misc. not needed links:
Dollar Rise Squeezes ETFs and Indexes

Dollar Rises and Sends Indexes Down Sharply

Global Financial Stability Report Navigating the Financial Challenges Ahead October 2009

IMF: "Risks to financial stability have intensified"

"Reserve Accumulation and Easy Money Helped to Cause the Subprime Crisis"

Unemployment and inflation

William Brock, Cars Hommes and Florian Wagener show how hedging instruments can destabilize markets.
http://www1.fee.uva.nl/cendef/publications/papers/arrowabridged.pdf

Watching America   :   » The China–U.S. Exchange Rate War

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