naked capitalism

By Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

The need to address and prevent future large global economic and financial imbalances is back on center stage, but it seems as if policymakers are unwilling to formulate a plan, let alone take action to prevent the imbalances from returning. This was made clear at the recent G20 meeting in Pittsburgh and a in a subsequent Bernanke speech.

The G20 Addresses Economic Rebalancing

What was achieved at the G20 meeting in Pittsburgh to help restore global economic balance? The short answer: nothing of any substance as reflected in the conspicuous absent of any mention of two subjects, i.e. currency adjustments and protectionism.

The US imbalances addressed in the statement include a savings shortfall and an excess of imports relative to exports. The stated objective was correcting these imbalances while achieving three goals: full employment, low inflation and a stable currency.

The expressed G20 vision is that policy-induced growth of demand abroad will allow the US to achieve both full employment and external balance. The vision represents a significant change in the publicly stated causes of the US trade imbalance. Until recently, the US had argued that the trade imbalance was the result of the unwillingness of China and others to let their currencies appreciate, as well as excess savings abroad. On the other hand, much of the rest of the world argued that the trade imbalance was the result of insufficient savings in the US and not the exchange rate. Now all agree that if demand is stimulated everywhere, including the US, imbalances will disappear without changes in exchange rates. However, given the trade rows in the past one cannot help but wonder if the continuing desire to promote domestic employment will stand in the way of rebalancing, even with increased global demand. Witness the ongoing US-China trade friction and the Opel kerfuffle.

The absence of any call for currency adjustments or condemnation of protectionist tendencies suggests that the leaders at the G 20 meeting were unable to agree on how to address the imbalances and decided instead to pat themselves on the back for the jury-rigged efforts to support financial institutions and fiscal stimulus measures that had already been adopted.

Bernanke Addresses the Global Imbalances

In a recent speech Bernanke said:

To achieve more balanced and durable economic growth and to reduce the risks of financial instability, we must avoid ever-increasing and unsustainable imbalances in trade and capital flows. External imbalances have already narrowed substantially as a consequence of the crisis, as reduced income and wealth and tighter credit have led households in the United States and other advanced industrial countries to save more and spend less, including on imported goods. Together with lower oil prices and reduced business investment, these changes in behavior have lowered the U.S. current account deficit from about 5 percent of GDP in 2008 to less than 3 percent in the second quarter of this year.

…As the global economy recovers and trade volumes rebound, however, global imbalances may reassert themselves. As national leaders have emphasized in recent meetings of the G-20, policymakers around the world must guard against such an outcome. We understand, at least in principle, how to do this. The United States must increase its national saving rate. Although we should deploy, as best we can, tools to increase private saving, the most effective way to accomplish this goal is by establishing a sustainable fiscal trajectory, anchored by a clear commitment to substantially reduce federal deficits over time. For their part, to achieve balanced and sustainable growth, the authorities in surplus countries, including most Asian economies, must act to narrow the gap between saving and investment and to raise domestic demand. In large part, such actions should focus on boosting consumption.

Bernanke makes no mention of exchange rate adjustment, but there is an acknowledgement of the need to increase the US savings rate or the imbalances will grow again. What does this recent talk suggest for the US contribution to global rebalancing and the rebalancing itself?

One, currency adjustments appear to have been ruled out. The G20 didn’t mention them. Bernanke didn’t mention them. The Administration “policy” seems to a mix of the “strong Dollar is in the US interest” mantra and a wink-wink-nudge-nudge policy of benign neglect. Between the perceived need to regain some international competitiveness on the one hand, and the fear that a Dollar depreciation would to weakened demand for Treasuries and higher interest rates on the other, US Dollar policy seems destined to remain non-existent. Internationally, Trichet is already complaining about the strong Euro and other countries appear willing to take steps to prevent any further appreciation of their currencies.
While currency adjustments were never sufficient by themselves to end global balance, it is difficult to see a successful rebalancing without some currency adjustment. The absence of any agreement to promote currency realignments does not bode well for global rebalancing.

Two, given that currency-driven adjustments have been ruled out. There is no operational plan to prevent the US external imbalances from growing again as soon as US growth resumes. While Bernanke acknowledges the need to raise the US savings rate, he again asserts that monetary policy should not have any role in promoting an increase in the saving rate. Bernanke believes that given it is better to have fiscal policy promote public savings rather than have the Fed or the fiscal authorities take steps to increase private savings.

However, does anyone believe that the President and Congress or any future President and Congress will permit external imbalances to drive tax or spending policies? Looking at the forecasted US fiscal deficits, does the word ‘austerity’ spring to mind? This is not the first time Bernanke presented an argument predicated on a very questionable assumption. In November of 2002, he gave a speech which included the following:

A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.

In light of recent history, the reference to a “well-regulated” banking system is telling. He was surprised in 2007. Had he verify the state of regulation in 2002? Did he re-verified in the midst of all the talk of financial bubbles? Will the Fed now set policy based on the premise that the President and Congress are about to embark on a campaign of fiscal austerity? Will he be willing to adjust monetary policy if large US external imbalances return and fiscal policy does not promote an increase in the savings rate? Bernanke continues to say no, although the Fed was quite happy to promote consumption/discourage savings post 2001.

Both the G20 version of rebalancing and the Bernanke version of rebalancing are decidedly deficient. There is nothing in the current or promised policy mix which suggests anything other than a return to unsustainable global imbalances that are incompatible with stable, crisis-free growth. Do US policymakers truly believe that they fulfill their obligation to the American people by assuming that policymakers in other counties will pursue policies so that the US can avoid the costs of adjustment?

The “economy is recovering” story is not reflected in traffic at LA area ports (LA and Long Beach, which combined are the fifth largest in the world). The outlook for the shipping industry is even worse on the whole than for traffic volumes, since many carriers did not cut equipment orders.

And while shipments are expected to improve 10% next year, industry experts do not see that as a rosy number, given the depressed levels this year. In addition, they see next year’s rebound as driven by inventory restocking rather than a real change in end user demand.

From the Los Angeles Times:

In another sign of how deep the global recession has become, the ports of Los Angeles and Long Beach on Friday reported their worst combined import statistics for September in nine years.

September is often the busiest month at the nation’s biggest port complex, making it one of the best barometers of the health of the economy and international trade.

The port of Los Angeles received 309,078 containers packed with imported goods in September, representing a decline of 16% from the same month last year and 27% from September 2006, L.A.’s best month ever for imports. Long Beach received 224,924 import containers in September, a drop of 19% from a year earlier and 32% from September 2007, the port’s best September ever.

For the first nine months of the year, imports, exports and empty containers through the port of Los Angeles were down 16% at just under 5 million containers while the Long Beach port saw a decline of nearly 25% at just under 3.7 million containers, compared with the same period last year….

…. a greater worry goes beyond the immediate and substantial loss of local trade-related jobs: Some of the ports’ most important tenants were so poorly positioned for the downturn that they might sink completely in a sea of billions of dollars of red ink, experts say….

Paul Bingham, managing director of global commerce and trade for IHS Global Insight, said his firm predicted a 10.1% growth rate next year over 2009 levels in international trade, but he added that the figure masked a great deal of weakness. Part of what will make 2010’s international trade figures a double-digit improvement over 2009 will be rebuilding inventories for warehouses, not direct sales.

Wolfgang Munchau, in today’s Financial Times, makes the case that a certain amount of dollar weakness is a good thing and consistent with global rebalancing. On one level, this is a sensible and defensible view. But this view is implicitly based on the idea that the dollar will somehow find its “correct” level, more or less.

But currencies are known for their propensity to overshoot and stay for long periods at levels not warranted by fundamentals. The yen is a prime example. Even with Japan’s lousy domestic economy, its large (until recently) trade surpluses would have argued for an appreciation of the yen. However, the currency stayed super cheap because the yen had become a funding vehicle. It was only when the carry trade unwound and domestic currency speculators exited their foreign bets that the yen rallied, and is now at levels that seem similarly unwarranted by the fundamentals. To his credit, Munchau does not see some welcome weakness of the dollar as a long-term solution; he highlights the need for structural reforms.

So Munchau is correct, there could be a happy ending here, but I’d be loath to bet on it. For instance, some took cheer that the US trade deficit narrowed. But that was due largely to oil imports contracting due to price increases. $70ish a barrel oil is hardly expensive by recent standards. If a recovery to that level can lead to a fall in demand, it says the economy is more fragile than most want to admit.

From the Financial Times:

Imagine a world with a small current account deficit in the US, a somewhat larger deficit in the eurozone and a not too excessive Asian surplus. In such a world, economic commentators would no longer bang on about global imbalances and would have to find a different subject.

In the long run, such a world would require significant reform of the international monetary system. In the short term, a fall in the dollar’s exchange rate would help get us there. And I note with some satisfaction that it is happening.

A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ….a strong dollar is the last thing the US economy needs right now.

There are two further factors that support a weaker dollar. The first is, of course, the double-digit public sector deficit, which has already unnerved investors and which is not going to come down with any haste. The second is monetary policy….

The latest published comments from Bill Dudley, president of the New York Fed, confirmed my suspicion about the Fed’s asymmetric bias when he said he was more concerned about deflation than inflation and that interest rates would stay low for a long time. This is 2003 and 2004 all over again, except this time the chances are higher that it will end in inflation rather than in a housing and credit bubble.

What about the rest of the world? Would the Europeans, for example, not fight tooth and nail against a weakening dollar? Not necessarily. Just look at the situation from the perspective of the European Central Bank. Ideally, it would like to exit early by withdrawing liquidity support and raising interest rates, but it is severely constrained because many European banks are still dependent on low interest rates and ECB life support operations for their survival.

Fiscal policy is also extremely loose and likely to remain so. From the ECB’s point of view, a strong euro is probably the most effective insurance against resurgent inflation, at a time when interest rate policy remains constrained.

A strong euro would nicely take care of Germany’s persistent current account surplus. The surplus countries will never adopt policies to get rid of their surpluses. The exchange rate will have to do the job for them. Last week’s announcement of a surprise fall in German exports during August tells me that the hopes of another export-led recovery, as in 2006, are unrealistic. I expect a much reduced current account surplus for Germany in the next few years and, for the eurozone, a sizeable, probably not excessive, current account deficit.

The sensible goal of a more balanced world economy is entirely consistent with a weaker dollar and a stronger euro. I am not trying to make a short-term prediction. Foreign exchange markets are crazy, and I have been wrong too many times. But what persuades me that the dollar has further to devalue is the observation that, for once, politics and economics are pushing in the same direction.

Exchange rates cannot solve the problem of global imbalances…. Reform of the global monetary system is necessary for sustained balance. I agree with the views of Fred Bergsten, director of the Peterson Institute for International Economics in Washington, that the world will ultimately have to move to maximum targets for current account imbalances.

In a forthcoming article in Foreign Policy, he proposes a current account deficit ceiling of 3 per cent of gross domestic product for the US. He also argues that a reduced international role for the dollar would be in the best strategic interests of the US as continued imbalances would end up producing intolerable instability, no matter whether they are financed or not….

It is important not to confuse the international role of a currency and its exchange rate at any particular time. But in the case of the dollar, there is a link. A fall in the dollar’s exchange rate would be a very useful contribution to global balance. A reform of the global monetary system is needed to ensure that imbalances do not return. We are not there yet, not even close. But some of the parameters are slowly falling into place.

A Bloomberg headline tonight is uncharacteristically alarmist: “Dollar Reaches Breaking Point as Banks Shift Reserves.” However, while the article is correct to point to lack of enthusiasm for the dollar, it presents, but then fails to integrate, a key point: foreign central banks are not cutting dollar holdings. In fact, they are still increasing buying dollar assets. But they have shifted their marginal purchases in favor of the euro and yen. That shift is playing into current dollar weakness.

We could be approaching a short-term inflection point. Sentiment on the dollar is very bearish, and its long-term outlook is not promising at all. But this could point to either another leg down (the beginning of a disorderly slide that many observers worry about) or could also produce a snapback rally if an unexpected rise led to short covering (particularly if equities markets rallies were to fade and lead investors to seek cover until the dust settled in Treasuries).

From Bloomberg:

Central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two- quarter rout in almost two decades.

Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63 percent of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That’s the highest percentage in any quarter with more than an $80 billion increase.

World leaders are acting on threats to dump the dollar while the Obama administration shows a willingness to tolerate a weaker currency in an effort to boost exports and the economy as long as it doesn’t drive away the nation’s creditors. The diversification signals that the currency won’t rebound anytime soon after losing 10.3 percent on a trade-weighted basis the past six months, the biggest drop since 1991.

“Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it,” said Steven Englander, a former Federal Reserve researcher who is now the chief U.S. currency strategist at Barclays in New York. “It looks like they are really backing away from the dollar.”

The dollar’s 37 percent share of new reserves fell from about a 63 percent average since 1999.

Some believe that developing economies may be selling dollars:

Developing countries have likely sold about $30 billion for euros, yen and other currencies each month since March, according to strategists at Bank of America-Merrill Lynch.

That helped reduce the dollar’s weight at central banks that report currency holdings to 62.8 percent as of June 30, the lowest on record, the latest International Monetary Fund data show. The quarter’s 2.2 percentage point decline was the biggest since falling 2.5 percentage points to 69.1 percent in the period ended June 30, 2002.

But some think a reversal later is possible:

Central banks’ moves away from the dollar are a temporary trend that will reverse once the Fed starts raising interest rates from near zero, according to Christoph Kind, who helps manage $20 billion as head of asset allocation at Frankfurt Trust in Germany.

“The world is currently flush with the U.S. dollar, which is available at no cost,” Kind said. “If there’s a turnaround in U.S. monetary policy, there will be a change of perception about the dollar as a reserve currency. The diversification has more to do with reduction of concentration risks rather than a dim view of the U.S. or its currency.”

However, despite the noise from the hawks at the Fed, the official pronouncements have all indicated that the Fed expects to keep rates low for quite some time.

Whoops, that was the old brand, and it was to be led by Japan. The results were less than happy since Japan was not prepared to take “no” for an answer.

But this time around, necessity as well as opportunity are leading China, Japan, and Korea to discuss moving forward on closer economic ties. In fact, the driver for talks appears to be more than a tad of desperation of the Japanese.

The US has been opposed to anything more than symbolic movements on this front. For instance, in the 1997 Asian crisis, Japan wanted countries in the region to lead rescue efforts. That idea was opposed, forcefully, by Robert Rubin, Larry Summers, and Timothy Geithner, who was then at the IMF but slotted to join the Treasury. And we know how that movie ended. The IMF “reforms” were the same template they had used for Mexico, and was inappropriate in key respects for high-savings Asian countries. The Asian tigers’ resentment of punitive and painful programs led them to institute currency pegs at artificially low rates so they could build up their reserves. China held its peg during the crisis at US request, reinforcing its use of pegs (and one can further argue that the low rates implemented in the crisis countries gave China plenty of cover to maintain its peg even as its currency became increasingly undervalued).

It is still not clear how serious this move is. There has been talk for some time of beefing up ASEAN (for instance, having it have its own development bank as an alternative to the World Bank). This initiative is outside ASEAN and is in the brave talk stage. The biggest potential obstacles is long-standing distrust among the principal actors. That may be compounded by China trying to assert a leadership role, which is understandable given its economic position, but diplomacy is not yet one of China’s strengths.

From the Telegraph :

The three countries, dismayed at falling levels of trade and investment from the US and Europe, met in Beijing to plan for more structured levels of co-operation.

The move came as HSBC warned there is likely to be a “shift in the world’s centre of economic gravity from West to East”. The bank has already decided to move its chief executive, Michael Geoghegan, from London to Hong Kong next February to prepare for Asia’s ascendancy.

Wen Jiabao, the Chinese prime minister, and his Japanese and South Korean counterparts, Yukio Hatoyama and Lee Myung-bak, said the three countries were “committed to the development of an East Asia community”, similar to the European Union.

The idea, which is being strongly pushed by Japan, could eventually lead to a free trade block and co-operation on public health, energy and the environment….

The proposals are in their early stages, and the three countries emphasised that it was a “long-term goal”. Liu Changli, a professor at China’s North East Finance University, said a free trade area could be in place “by 2020, on a best-case scenario”. He added: “Add another five to 10 years for an economic union and a further five to 10 years after that for a true economic, military, political and cultural union”.

The proposals come as Japan is struggling with the collapse of its export sector, a key motor of its economic growth. Since Mr Hatoyama was elected at the end of August, he has been searching for a way to kick-start the economy and alleviate the country’s debt, which currently stands at 283pc of GDP, the highest of any G20 nation….

South Korea’s ties with China have also weakened, with substantial Korean populations in Beijing and Shanghai returning home because of the downturn.

Both countries now see China’s booming economy, which is set to grow by at least 8pc this year, as a beacon of hope. China, for its part, has a long-term strategy of reducing its dependence on the West and building political and economic ties with Russia, the Middle East, Africa, Latin America and Asia. It has already signed a bilateral free trade agreement with ASEAN, the coalition of South East Asian nations, which is due to come into full effect next year.

However, any attempts by the three nations at closer integration are likely to be opposed by the US, which is concerned about any waning of its influence in the Pacific.

Japan’s role in this is a clear statement of diminished US power. Japan is a military protectorate of the US. For at least the last three years, if not longer, Japan has been playing a very careful game between the US and China. It appears to have decided it has little to lose in seeking to throw its lot in with China.

An unannounced but evidently coordinated effort to arrest or at least slow the fall of the dollar is underway. The Financial Times indicated that Asian central banks were aggressive dollar buyers on Thursday, but the information came via currency traders rather than an official pronouncement. Thailand, Malaysia and Taiwan made substantial purchases; Hong Kong and Singapore also intervened today. The action may also have a secondary objective of rejiggering their currency values versus China’s, since China repegged the renminbi against the dollar.

However, these efforts were seen by traders as merely an attempt to control the fall in the dollar rather than halt it. And other markets responded to the dollar weakness. Oil prices rose nearly $3 today, gold hit a new high in dollar terms, and copper and tin spiked upward. The dollar is strengthening overnight on Bernanke’s empty promise that the central bank will raise rates when the economy recovers.

The dollar’s weakness exposes a series of dilemmas and a lack of obvious remedies. Normally, a country experiencing a financial crisis takes measures to depreciate its currency so it can use an export boom to help pull itself out of its economic mess. However, Paul Krugman, among others, have pointed out that trade has collapsed, so even if one were to break glass and trash currency, it isn’t as effective a solution as it would normally be. And even if that approach might work, with so many countries affected by the crisis, it’s too easy for currency depreciation to lead to beggar-thy-neighbor competitive devaulations.

Although the US keeps mouthing its “strong dollar” assurances, many observers believe that the Obama Administration is content to let the dollar slide because the resulting inflation will help erode the value of debt and more robust exports will help growth. But that seems a trifle optimistic. First, some economists, such as Jim Hamilton, argue that it was the commodity price runup of early 2008 that pushed over-indebted consumers over the edge. Commodities inflation, when it inures to the benefit of foreign producers, is not a boon to the US. Second, the US has ceded a lot of manufacturing industries. How long would the dollar have to stay weak for the US to repatriate significant amount of, say, furniture and shoe fabrication? These are two industries where some incumbents insist the US could remained competitive in high-end and even some mid-level manufacturing (offshoring was driven not just by cost savings but also by a desire to please Wall Street analysts). It takes time to establish operations and hire and train staff. No one is going to make investments like that unless they are confident the dollar will remain comparatively weak.

Third, rising inflation is not a panacea. While it reduces the value of debt currently outstanding, it also makes it costly to sell new debt (unless the borrower is convinced inflation will rise even higher). Even if the principal will be paid back in depreciating dollars, the cost of debt service rises with higher interest. And having lived through the inflation-ridden bond markets of the early 1980s, no one wanted to be borrowing then. Reasonable credit quality companies were facing 15+% coupons.

Even before we get to anything resembling that level of interest rate, the Fed and Treasury have a big bind. Higher domestic inflation means higher interest rates. Higher interest rates mean higher mortgage rates. That kills housing. Higher interest rates also means all those private equity owned companies that are stuffed up to their eyeballs in debt and need to refi between now and 2013 find it more costly. Many will not survive higher debt service. Big bankruptcies and related job losses are not too good for economic recovery. The Treasury has also gotten addicted to super low interest rates (and if my correspondents are correct and the average maturity of Treasury debt has shortened, the US is more exposed to interest rate increases than it might otherwise be). In other words, even a modest increase in rates could have a much nastier economic impact than conventional wisdom assumes.

And we have another possibility. At the G20, the US started to take up the “we want to be an exporter when we grow up” theme. Ahem, so who is going to be the net consumer if the US gives up that role? Now I will be the first to concede that having a world where more countries had robust consumer sectors and were less export dependent would be a much better arrangement, but getting there is at least a 10 year, probably more like a 20 year transition. Yet the powers that be here are acting as if the US can beef up its exports and get to a net neutral or a net exporter position much sooner. So was that unannounced Asian intervention benign, or was it a bit of a warning shot, that the rest of the world reluctantly accepts that the dollar probably needs to be cheaper, but will only let that go so far?

When Jim Rogers taught classes at Columbia, he liked to tell students that the US had a proud history of implementing capital controls, and warned them against going on the merry assumption that it would ever and always be easy to make cross-border investments. For instance, taxes on foreign securities transactins are a soft form of control and have been used to facilitate or restrict cross-border capital flows. The US lowered them when it abandoned Bretton Woods in 1971 to aid in adjustment of the price of the greenback.

Despite the hue and cry that we must keep trade and capital flows open, I have long believed that they would be restricted as financial reforms moved forward. The Carmen Reinhart-Kenneth Rogoff work shows convincingly that periods of high international capital mobility are associated with frequent banking crises. They do not assert that the relationship is causal, but I suspect it is. Capital that can move easily across borders is by nature difficult to regulate. It would require a considerable sacrifice of national sovereignity to devise rules and organizations that could do an adequate job of supervision. So a high level of international investment flows means lawless or seriously underregulated financial firms and activities. And we have just seen that this lawlessness eventually exacts unacceptably high costs to the real economy.

Thus, measures to increase stability that will be effective can only take place on a national level, and they further require at least some restriction of cross border flows. But how that would come about remained a mystery to me, hence my silence on this topic. Everyone seems wedded to the prevailing ideology of “fewer international restrictions are better.” Indeed, some have decried how awful it would be if the world were to revert to largely national pools of capital, depicting it as a financial Dark Ages. But would it be a Dark Ages for the economy, or merely for bankers?

Russell Napier in today’s Financial Times, describes how capital restrictions might come about, and his case is entirely plausible. The interest of high finance are increasingly opposed to those of governments. Capital will want to flee to havens which are not suffering from the need to work off enormous bank rescue costs. But those very same governments will find it necessary to keep funds at home to earn a return to work down those very same expenses. Hence capital controls.

From the Financial Times:

One consequence of the financial crisis is that fund managers are increasingly going to come into conflict with governments…

Developed world governments are desperate for finance; they will attempt to constrain private-sector credit growth and are likely to ease the economic pain with inflation and exchange-rate depreciation.

This differs from the environment of the past few decades when investors were happy to save in their own currencies, buy government debt and participate in credit-fuelled domestic asset booms. Will fund manager fiduciaries now be prepared to finance record fiscal deficits? Will they buy domestic assets in an era of sub-par credit growth? And will they buy shares in banks stuffed with government credit and loans aimed at securing employment rather than sound returns?

If they don’t, how much capital will they export? Indeed, might they consider it prudent to short government debt to protect their clients’ wealth? To protect against inflation, might they buy commodities?

This may all look necessary to fiduciaries, but governments will view it as speculating against their currencies and driving up the cost of government financing. Governments will not stand by and watch what they might come to term “capital behaving badly”.

Until 2008, capital colluded in maintaining the myth of prosperity, by providing the credit for excessive consumption. Capital supported the illusion of savings by pumping up equity valuations to ridiculous levels; and it supported the need to speculate, most notably in the housing market, by manufacturing savings that could not be earned. This support ended with a bang, and governments stepped in to prevent the deflation that would have brought poverty all too quickly.

The first emergency step was to partially nationalise commercial banks, but government interference with capital allocation will not end there. The need to bail out the banking system accelerated the public debt crisis that was coming anyway, due to the baby-boomers’ failure to save for their retirement. Once known as the ‘Grateful Dead’ generation, their demand for pensions and healthcare will mean they will increasingly be seen as the ungrateful undead. The political necessity of supporting their claims will drive government further into the capital allocation business.

Governments still need the support of capital to ensure that the myth of prosperity dies slowly. If that support is not provided willingly, history shows that governments can conscript capital to the cause. So what sort of “national service” can we expect ?

A transaction tax on financial instruments is very likely… A suitably high transaction tax would force investors to hold shares for much longer periods and to engage management to control risk. This would reduce the need for governments to police risk-taking in corporations. What could be more laudable than a tax that turned everybody into Warren Buffett?

Capital controls are also more likely than investors believe….There is an inherent conflict between western governments’ need for finance to sustain living standards and capital’s need to seek out the greater growth opportunities in emerging markets. Whatever the long-term benefits in boosting returns on savings, the short-term political necessity of public financing is likely to necessitate slowing capital outflows.

Capital controls seem impossible to many, but when a choice has to be made between economic principle and government bankruptcy, they are a likely political response

Japan is a case study in the cost of losing control of capital flows. The government made it easy for retail investors to buy foreign currency investment, with the logic being that yen-based returns were so low, savers needed to be allowed the opportunity to earn higher yields overseas. Unfortunately, a cadre of retail FX traders, every bit as manic as US day traders and holding even more funds in aggregate, now dominates yen trading. The government now has more impediments than it otherwise would have in influencing the level of the yen thanks to this self-inflicted wound (not that currencies are easy to manage even in the best of circumstances, but this policy has made a difficult task even more fraught).

Submitted by Edward Harrison of Credit Writedowns

I have to admit to hyping the debate now swirling about protectionism. I believe that tariffs are not a very good solution to a trade problem as they are likely to result in retaliation and/or escalation. Moreover, they end up protecting small groups at the expense of higher prices for everyone else.  That is why I wrote the provocatively-titled “Murder-Suicide in Chimerica.”

But taking a step back from the rhetoric for a second, I want to highlight two recent articles and make a few comments.

Is the protectionist bogeyman really coming?

First, while a protectionist backlash is a distinct possibility which I see as the main threat to sustained recovery, I recognize that countries like China and the United States are co-dependent and loath to permanently altering the status quo unilaterally. So while I condemn the recent tariffs imposed on Chinese tires, I recognize that the tariffs were imposed in the calculus that this issue would not or could not escalate.

This is what James fallows argues in a post yesterday:

I keep putting this off, so before it finally disappears into the mists of time, here is a bullet-point summary of what I would have said at greater length when the Chinese tire tariff first arose.

1) There is not now, and there never was, a serious possibility that this would escalate into some sweeping, self-intensifying, global-recovery-threatening “trade war.”  The many publications and commentators who raised their hands in “Oh no! It’s Smoot Hawley again!” horror need to calm down — and to have their tendency toward over-reaction noted for the record. Yes, I’m talking about you, Economist magazine cover-designers (last week’s cover image, below), but you had tons of company.

There is too much going on, on too many other fronts, involving affairs of incomparably greater consequence between China and America, for this to have been more than a contained, specific dispute — contained in both duration and sweep. This was clear at the time and should have buffered the shock-horror tone of the stories. Why this matters: because of the  boy-who-cried-wolf principle. There are issues between China and the outside world in which a small disagreement could spiral into a very dangerous confrontation. Many of these involve Taiwan, for reasons to be spelled out another time. But tire tariffs, agree with them or not, were never going to set off a global economic confrontation.

In effect, Fallows is saying that it undermines ones argument to scream, “Smoot-Hawley, Smoot-Hawley” every time there is some issue that deviates from the idealized world of free trade. Eventually people will block this out, especially in an environment like this, in which populist sentiment is running high. Fair enough.

Protectionism is more than just tariffs

So with those thoughts in mind, I read Edmund Conway’s article “We are entering a new age of protectionism” in the Telegraph. Conway says:

Some are “traditional” measures, familiar from the Depression and elsewhere – subsidies for domestic producers or tariffs on imports, President Obama’s move to slap a 35 per cent charge on Chinese tyres being a prime example. Such measures are provoking fury, and with good reason: the protectionist spiral into which the world plunged in the 1930s almost certainly contributed to the war at the end of the decade.

However, such visible signs of protectionism tell a fraction of the story. For the shocking truth is this: over the past year, the costs and obstacles faced by exporters have, according to a study by economists David Jacks, Christopher Meissner and Dennis Novy, increased by almost the same scale as in the early 1930s when the US and others were imposing a range of protectionist laws, including the infamous Smoot-Hawley Act.

Partly this is one of the perverse consequences of the financial crisis, which crippled the system of trade credit that underpinned the international flow of goods, making it impossible for some companies to ship products from one part of the world to another. But, far more worryingly, it is also a product of explicitly protectionist measures imposed by countries such as the UK in an effort to save their domestic banking systems from collapse. Most egregiously, these included so-called financial mercantilism, whereby governments, having rescued a bank, insisted that it had to lend far more to domestic customers than business or individuals overseas businesses.

This new protectionism is a different beast from that of the early 20th century, but the result is the same. According to the Bank for International Settlements, the amount of money flowing across national borders has collapsed in a way never before witnessed. Put simply, financial globalisation, which helped power economic growth in recent years, has gone into reverse over the past year. All the more worrying is that it has done so without people noticing.

If I read Conway correctly, he is rightly pointing out that all the bailouts and subsidies we have seen – especially in the financial sector – are the economic equivalent of tariffs.  Protectionism is not just about tariffs. We are moving to a world in which domestic jobs are ‘protected’ via non-tariff remedies.

Extending Conway’s argument to the auto industry, it should be patently clear that this is what is happening. Here are a few posts I wrote on the issue.  The titles should give you the gist.

• Volkswagen: if the American carmakers can get bailout funds, so can we – Dec 208
• Sweden: competitive auto bailouts begin with Saab and Volvo – Dec 2008
• Germans reject Chinese offer for Opel – Jul 2009
• Cash for Clunkers will put GDP over the top in Q3 – Aug 2009

Every car company has its hands out for a subsidy or bail out and most of them are receiving it. Certainly, the U.S. has led the way, but the Germans have been as bad as anyone here.  The deal that the German government struck to save Opel with Magna, a Canadian-Austrian auto parts manufacturer, is widely perceived as having been slanted in favor of German jobs over Spanish, Belgian or British.  All of these countries are complaining bitterly to the EU that the deal represents a subsidy and is anti-competitive.

This is why you see the Germans talking up regulatory reform in finance and the Americans and the British are talking up re-balancing:  The U.S. and the U.K. have strong financial services industries and Germany has a strong export sector. Of course the Americans are opposed to financial reform.  Of course the Germans don’t want global rebalancing.

Politics is domestic

In a prior life I was a foreign policy guy.  In my time living and breathing foreign policy it became evident to me that politics is always domestic first.  If you want to know why a foreign leader is acting a certain way or taking a specific position, take a look at the domestic political environment.

Do you think the Chinese cared what Americans think, when they threatened to retaliate to the tire tariffs? Do you think Angela Merkel cares what happens to workers at Vauxhall plants in the U.K. when she arranged the Magna deal? Do you think the Americans care about what happens to Frankfurt as a financial center when they bailed out BofA and Citgroup? Of course not.

What matters is placating domestic concerns and consolidating power domestically. So while I talk about the “cozy” relationship between China and the U.S. as a marriage, I am under no illusion that this is anything more than a business relationship. When push comes to shove domestic concerns will win out. And if that means placating rioting workers in fear of losing jobs, so be it.

Expect more, not less protectionism

So I am not optimistic this protectionist wave is going to go away. My baseline sees more not less protectionism.  What would be wonderful is if the recovery taking hold were robust enough so that nations came together and worked out a workable forward-looking global solution to some of the more intractable macro problems. However, for the time being most people are retreating to their corners, making protectionism a continued threat.

This post has been deleted temporarily because it appears to be corrupting the RSS feed. It will be restored once we have isolated the problem.

It would be better if we were not proven correct on this one, but when the US imposed stiff tariffs on imported tires from China late on Friday, we noted, “This could get interesting in a bad way.” The Chinese responded quickly over the weekend to announce they were investigating US auto parts and chicken, which together account for roughly as much as the disputed tires ($1.2 billion versus $1.3 billion for tires).

It is if nothing else getting interesting fast, and it certainly does not look good. The Financial Times branded the harsh reaction from China as elevating the US action to “a full-blown trade row.”

When trade volumes plunged late last year, most commentators expected a rise in protectionism. There hasn’t been much in the way of overt action, yet, perhaps in the hope that government intervention would work and the crisis would pass quickly.

But protectionism is driven by the desire to protect jobs. Unemployment has not peaked in the US, and some analysts suggest that China’s job losses are far worse than the 20 million often bandied about, more on the order of 30 to 50 million. So political pressure is set to intensify.

The New York Times treats the Chinese reaction as a surprise. But the tire tariffs relied upon a special provision in the WTO agreement for China’s entry that set a lower bar for trade violations than the normal anti-dumping sort. This is the first time that rule has been used as the basis for an action against China, and China may feel it important to fight that precedent.

From the New York Times:

China unexpectedly increased pressure Sunday on the United States in a widening trade dispute, taking the first steps toward imposing tariffs on American exports of automotive products and chicken meat in retaliation for President Obama’s decision late Friday to levy tariffs on tires from China….

Eswar Prasad, a former China division chief at the International Monetary Fund, said that rising trade tensions between the United States and China could become hard to control…

“This spat about tires and chickens could turn ugly very quickly,” Mr. Prasad said.

China exported $1.3 billion in tires to the United States in the first seven months of this year, while the United States shipped about $800 million in automotive products and $376 million in chicken meat to China, according to data from Global Trade Information Services in Columbia, S.C.

For many years, American politicians have been able to take credit domestically for standing up to China by taking largely symbolic measures against Chinese exports in narrowly defined categories…For the most part, Chinese officials have grumbled but done little…Now, the delicate equilibrium is being disturbed….

But the timing of the announcement — on a weekend and just after the tire decision in Washington — sent an unmistakable message of retaliation. The official Xinhua news agency Web site prominently linked its reports on the tire dispute and the Chinese investigations…

The bigger risk for China, economists and corporate executives have periodically warned, is that trade frictions could cause multinationals to rethink their heavy reliance on Chinese factories in their supply chains. The Chinese targeting of autos and chickens affects two industries that may have the political muscle in the United States to dissuade the Obama administration from aggressively challenging China’s policies.

DoctoRx gives a Pangloss watch update from Bloomberg: Obama’s China Tariffs May Be Prelude to Opening Trade